Young investors usually start off investing in stocks through mutual funds, often through retirement vehicles like 401k funds and IRAs. In many cases, single stocks (stock in a single company) don’t enter into an investor’s portfolio until much later. Often, the first time an early-stage investor owns a single stock is when they are granted some stock in their own employer firm as part of an incentive program.
What should this young employee do with their new stock? They believe their company is going places, and they might have heard some office chatter about how much money their coworkers have made by holding stock during a recent period of rapid growth.
I’m going to make an unpopular recommendation. Do not invest in your own company, and if you own shares already, sell them!
One good reason to sell and lots of bad reasons to hold
This is a unique situation. Oftentimes in investing, you can make a convincing case for both sides of an argument. A few examples– there are good cases for both:
- value and growth stocks
- international stocks and domestic stocks with international exposure
- going at it alone and paying for a professional adviser
- active versus passive investing
But this is a rare case where I think there is one right answer. You should not invest in the stock of your employer firm if you can avoid it.
Expand your perspective beyond your investments, and consider your entire life as your portfolio. With the larger perspective, you’ll see that your professional career might be the biggest asset you own, especially if you are under 45.
Modern portfolio theory is based on the power of diversification
Most of contemporary investing theory has at least some foundation in Modern Portfolio Theory, developed in 1952 by Harry Markowitz. The idea is that the goal of investing is to maximize expected returns, while at the same time minimizing expected risks. The insight of Modern Portfolio Theory is that this goal can be achieved through portfolio diversification. A diversified portfolio owns many partially unrelated assets, so that bad news for one asset can sometimes be offset by good news in another. This allows an investor to achieve an appropriate level of return with lower than normal volatility.
This concept has a direct application to retirement savings, beyond diversifying within an investment portfolio. Expand your perspective beyond your investments, and consider your entire life as your portfolio. With the larger perspective, you’ll see that your professional career might be the biggest asset you own, especially if you are under 45.
What’s different about early stage investors?
Young investors are susceptible to market swings just like everyone else. But, for a thirty year old, the biggest determinant of her retirement nest egg has almost nothing to do with what the market does in the next ten years. Instead, it has a lot to do with whether she climbs a few rungs on the corporate ladder, splits away to form her own firm, or gets laid off and is forced to job search for 14 months.
And what is the biggest determinant of how the next ten years of her career will go? In a lot of cases, the biggest factor is how well her company performs financially during the next few years. Companies that are growing fast throw opportunities for advancement all over the place, and companies that are in decline get very stingy with the raises and promotions.
In other words, in portfolio terms, you already have a very large, illiquid investment in the firm you work for. And if you take diversification seriously, you should not be investing even more of your overall wealth into the same company.
But I think my company stock price is about to go way up!
This is probably the most common reaction I get when I advise a client to divest their employer stock holdings. Particularly because a lot of the people I talk to are early-stage investors in their 20s, 30s, and 40s. These investors are at a point in their careers where they might be climbing through the ranks, achieving professional success in a firm that seems to be doing quite well. However, there is a statistical flaw in this thinking.
Employees tend to overestimate the prospects of their own firm in the stock market. To understand why, let’s try a simple thought experiment.
In other words, in portfolio terms, you already have a very large, illiquid investment in the firm you work for. And if you take diversification seriously, you should not be investing even more of your overall wealth into the same company.
Why employees are worse than random people at evaluating their company
Assume that the general population consensus is able to accurately estimate the stock market prospects of a firm. This is an example of the wisdom of the crowd phenomenon. Now lets build a firm using a random sample of the general population. On day one, our employees, in aggregate, will be able to accurately estimate the stock market prospects of our firm.
But lets think about day 2, and day 100. As time goes on, some employees will like working at our firm better than others. In fact, there will probably be a bell-shaped distribution of “employee satisfaction”, with most people viewing the company as a so-so place to work, alongside a few misanthropes, and a few annoying cheerleader types. The company will also experience some turnover as people are fired and quit.
However, the misanthropes will be over-represented in the turnover. The unhappiest employees will quit more often, and be fired more often, than the lukewarms and the go-getters. So over time, our employee pool will no longer match the general population in enthusiasm for our firm. Our firm is slowly but constantly filtering out nay-sayers. So, the remainder is going to predict our firm’s future just a little too nicely. By slowly removing the negative people, we have ruined the wisdom of our little crowd.
So, as an employee in good standing, odds are that YOU are overestimating your firm’s economic prospects. It’s not a reason to panic, but it is a good reason to ignore your own judgment in this matter. As a corollary to this point, you should also ignore your coworkers’ judgement in this matter. Our next two points cover this.
But my company management encourages people to invest!
Firms often formally and informally encourage their employees to invest in company stock. Formally, they can steer employee 401k retirement fund selection towards company stock by offering it as a prominent choice, or even as the default choice. Informally, managers can “just ask” if you are invested in the company. Bosses can talk about the stock at the water cooler, and employees may feel like they aren’t being team players if they don’t join in the conversation as dedicated “company people” if it becomes clear they don’t own any stock.
I strongly recommend you completely ignore this pressure. If you want, you can set a Google alert for your stock ticker, so you can join in the watercooler chats. You can even leave ten or twenty bucks worth of the stock in your portfolio if you don’t want to lie about how your company stock did in the market yesterday.
If your employer is pressuring you to own their stock, they are actively harming your financial future, and you shouldn’t feel bad or disloyal ignoring or resisting this pressure.
But all my older coworkers talk about is how much money they’ve made!
This is a trickier problem. There is a statistical reason why lots of people feel indirect pressure from their more experienced professional colleagues to invest in company stock. Let’s try another quick thought experiment.
Assume you are an early or mid-career newly hired employee at a firm. Your new 401k plan automatically invests a few percent of your salary into company stock. You are wondering if you should keep it there, or re-allocated it to a diversified mutual fund. To get some advice, you reach out to some more experienced colleagues that have been around a while and have a better idea of how things are going at the company.
And they all answer with amazing stories about how much money they have made in the past five or ten years by keeping their investments in company stock. And they’re still optimistic about its prospects. They aren’t lying, but you still shouldn’t listen to them.
What’s missing from our thought experiment?
In our little thought experiment, we left as implicit a very important detail. We just got hired at this firm. Successful firms hire people, failing firms fire people. So all else being equal, the fact the we just got hired is a weak but positive signal that our firm might be growing more than the average firm in the market. And because firms generally hire in response to market growth, and not in advance of market growth, we have to take our coworkers recommendations with a grain of salt.
In other words, we have several events here:
- A period of company growth over the last few years
- Strong stock market performance of our firm’s shares
- Us getting hired at the firm
These events are all correlated and dependent! And also, these events are all poor predictors of our company’s financial future. Just because it was growing before doesn’t mean it will still be growing now.
If you are a new employee at a company, your coworkers have an above-average chance of having recently experienced abnormally good performance of their stock holdings in the firm. They are still going to be riding that high, and they aren’t going to be in a good position to offer good stock investing advice. You can safely ignore their recommendations.
My most poorly-received financial advice
There’s a joke that economists make: the more consensus amongst economists, the less popular the opinion. In other words, the vast majority of economists agree on a few things. Freer trade is good, rent controls are bad. But these are the subjects where no one wants their opinion. On other matters, like tax policy and safety net programs, there is a high public demand for economic analysis but little consensus amongst the professionals.
I feel like this applies directly to the subject of employee stock incentives. To a professional investor, it’s quite straightforward that diversification is good and that owning stock in your own company is an unnecessary risk. But most people looking for investment advice are very, very attached to their own company’s stock.
It’s one of a very few highly confident recommendations I make, and unfortunately it’s one of my least followed! I’m hoping that the arguments in this post will win some people over.
A quick caveat
This advice applies only if the company stock that’s available to you is standard, market-value stock. Some companies offer company stock at a discount to employees, and some stock ownership plans have penalties for early withdraw. In these cases, you just have to consult a financial adviser, like me!
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