There is a tendency among several individuals to invest in companies they work for. The argument is they understand the company’s business well enough to ‘know’ the stock is a good investment. In this article, we discuss the risks associated with such investment. We also discuss why individuals make such investments and how to moderate the risk.
Two-asset portfolio
All working individuals have two assets viz human and investment capital. Human capital refers to the present value of future active income viz. the income we earn using skills. Determining this value is difficult. We save some from our post-tax monthly income and build wealth.
This is our investment capital. When you start your career, your human capital is large, and investment capital is near zero. As career progresses, human capital decreases and investment capital increases.
It is logical to diversify two-asset portfolio. As human capital is tied to employer, returns on your investment capital must come from other sources. In other words, if you work for an automobile company, it is best your investments are not tied to the firm.
A worst-case scenario is an individual losing her job because her employer is downsizing, which could lead to a dip employer-company’s stock price. If you are a senior-level executive, it is highly likely you are offered stock options by the company.
The above argument is not to suggest you should not accept such stock options. Rather, the discussion is to be mindful of the associated risks of having your human capital and a significant proportion of investment capital tied to the same source.
Conclusion
You must treat your employer stock as you treat any other stock — sell when you have decent accumulated gains. But most individuals do not.
The reason has to do with prediction overconfidence bias — individuals mistakenly believe they understand the company’s financial health and ‘know’ the stock will perform well. There are two ways to moderate this bias. One, invest in exchange-traded funds (ETFs) or mutual funds for your goal-based investments.
That leaves you holding employer stock in your satellite or trading portfolio. That may not hurt you because you will actively buy and sell shares in your trading portfolio.
And two, it would be optimal to cap your investments in your employer-stock to not more than 5% of your total equity investments.
(The author offers training programmes for individuals to manage their personal investments)