I had an interesting conversation at work today. One of my friends (let’s call him “the Spaniard.”) works for a large company.
It turns out his company gives him a pretty sweet deal. Every year he is able to buy up to 5% of his salary in the companies stock. The sweet part of the deal that he can buy it at a 15% discount to the market rate.
So essentially on day two, one day after buying his stock option, he has a guaranteed 15% return.
The conditions? He must hold the stock for a minimum of three years.
Which raises a few important questions.
1. Is this a good deal?
And
2. What should he do after three years?
And
3. What are the tax consequences of changing stock positions after three years?
Before we discuss these questions, it is important to distinguish between the concepts of compensated and uncompensated risk.
Compensated risk simply means risk that you’re paid for. Great examples of this include equity risk, and small size risk.
When you invest in Stocks (equity) versus bonds, or in small stocks versus big stocks, you’re investing in a more volatile asset with a greater risk of lost value. In exchange you get a higher expected return on the investment over time.
Over long periods of time, (at least 20 years.) Stocks will almost always return more than bonds. And small stocks will almost always return more than large stocks.
That’s the compensation in “compensated risk.”
But what if you hold your entire investment portfolio in one companies stock?
Every bit of specific news about that company will subsequently affect its stock price.
In addition every bit of news about the companies sector will have a dramatic effect on the stock price.
This means that the company stock will be significantly more volatile (risky) than the overall stock market.
And worst of all, what if that company is the fifth largest investment bank in 1997?
That’s right, I’m talking about Bear Stearns.
Imagine being an employee who had been getting company stock options for 10 years in prior to the financial collapse?
One Day after Bear Stearns goes bankrupt all of that money is gone.
Approximate value of 5,000,000 in Bear Stearns stock options on March 16 2008
And were the employees’ returns higher up until the point at which Bear Stearns went bankrupt when compared to say, having invested in the entire the entire financial sector or all large-cap stocks? Were the employees being payed for the risk they were taking?
Why no, they weren’t.
Which is where the “uncompensated” part of uncompensated risk comes in.
When you own more than 10% of your portfolio in any one stock, you are taking on the small risk of a devastating event substantially shrinking your investment. (And the devastating risk of this particular company going broke would be even more tragic for an employee. In addition to losing his nest egg he would likely be out of a job.
And in return for his risk exposure he gets a whole lot of nothing. No increased expected returns. No decreased volatility. No nothing.
In fact the only real guarantee is that of increased volatility, which we have already learned decreases annualized returns.
Simply stated, a risk not compensated is a risk not worth taking.
But back to the Spaniard.
My answers to questions 1,2 and 3 would be thus:
1. A guaranteed immediate return of 15% is more than enough compensation for the temporary risk of a concentrated position in a single stock (as long as the company is not demonstrably at high risk of near-term bankruptcy.)
2. After three years he should sell his company stock and buy inexpensive index mutual funds or exchange traded funds with good diversification (at least 100 companies held in each mutual fund.) Thank you Gift Horse, your teeth look a bit horsey but well enameled.
This will eliminate the uncompensated risk of stock concentration with no future loss of expected returns. (the risk is diversified away.)
3. The tax consequences of selling his stock in order to buy mutual funds are not insignificant. He will have to pay a 15% long term capital gains tax on all profits that his stock has made in the prior three years. But the best time to take this hit is right now.
Why? Because one year from now probability says he would have even more money earned on his investment , and thus a higher tax liability.
It will likely never be cheaper than now for him to walk away from his uncompensated risk.
And an uncompensated risk is a good risk to walk away from.
And if it is painful to take the tax hit right now, why not put the money into a backdoor Roth IRA?
The temporary loss of 15% in long-term capital gains taxes will be dwarfed by the hundreds of percentage points of future tax-free growth and tax free withdrawals in his new Roth IRA.
As a side note please remember that one is never taxed on principle invested, only on the money made from the returns on that principle. (And ignore talking points claiming that capital gains are “taxed twice.” They aren’t. This would only be true if the principal were taxed, which it isn’t.)
