Reduce Your Risk by Diversifying Away From Your Company Stock
By Robert J. Pyle
December 10, 2009
The past 2 years has proved to be a very trying time for individual investors. The overall market was very volatile but individuals stocks were even more volatile. Behavioral finance biases play a big part in trying to diversify away from company stock. The familiarity bias leads one to overweight stocks where you have some familiarity or local knowledge. Another bias is called self attribution bias which leads one to attribute success to expert knowledge but failures (losses) to randomness or things beyond your control. Helping the client to realize that they have these biases will make them a more successful investor.
To combat these investor biases, we have been creating plans for reverse dollar cost averaging. We try to set up a schedule for the client to follow to reduce exposure to company stock. First we look for possible tax losses on ESPPs. Then we work on NQSOs and ISOs. I would like to see a 25% gain from the strike price of stock options before we think about exercising them.
We figure out how many years remain until the options expire and then multiply by four quarters. Then we set up a schedule to sell shares in approximately equal increments each quarter until the options expire. This method allows the client to dollar-cost-average out of their large position in their company stock and move into a more diversified portfolio. Finally, if the client has a gain in ESPPs, they can sell some of these shares and offset capital losses in their taxable account.
For year-end planning, look to net gains and losses of company stock with a diversified outside portfolio. For example, if you have losses in your diversified portfolio, look to sell company stock with gains to net out losses and gains.
When someone sells, I look at ESPP shares first because you can net gains and losses out to minimize taxes (see above). The options have more chance of a large return because of the leverage factor. With restricted stock, I would sell in equal increments on a quarterly basis to get to zero exposure at retirement.
Another new development allows investors to hedge their stock options by selling call options (Options for Your Options) and use their options as collateral. In the past, if investors sold call options, they were considered naked options and required much larger margin requirements but the new law allows investors to use their stock options as collateral.
If clients’ absolutely have to keep a large concentrated position they should hedge their positions by buying puts and selling call options, thus creating a collar to help minimize volatility. We show them the effect of having a concentrated position and the risk it imposes to their financial plan with Moneyguide Pro – a financial planning software program. We try to nudge them to have zero exposure to their company stock when they retire and no more than 5-10% before retirement.
Robert J. Pyle is the President of Diversified Asset Management, Inc., an investment adviser registered with the SEC and based in Boulder, Colorado. The firm provides personal wealth management for successful executives and small business owners in the front-range who want to plan for and maintain a sustainable enjoyable retirement. This column reflects the views of Mr. Pyle and is not a recommendation to buy or sell any investment. It does not constitute investment advice. If you require investment advice, you should formally engage the services of a professional to assist you with your specific goals and needs.