One of the most common windfalls of wealth can come from employee equity compensation. Often, this happens when you’ve worked at a private company that experiences an Initial Public Offering (IPO), and the share price appreciates dramatically once it enters the publically traded market. However, you can also experience a windfall with a publically traded stock that experiences a dramatic rise causing your stock options (or equity position) to represent a large portion of your investment assets.
You can analyze many factors in whether or not to diversify your stock position. I’ll be primarily discussing incentive stock options (ISOs), but many factors for determining diversifying can apply to any concentrated stock position.
The overall message you should remind yourself is that “concentration builds wealth and diversification maintains wealth.” The decision to diversify should be based on your long term financial plan. Let’s discuss it!
Here are the seven biggest factors for determining how to diversify a concentrated employee stock option:
1) How close are you to financial independence (aka retirement), and how much “diversified investments” do you already have relative to the concentrated stock position?
Whenever you think about your investment portfolio construction, you should factor in how on track you are to achieving financial independence. It’s easier to make realistic return assumptions with a diversified investment portfolio from a financial planning standpoint than it is with an individual stock position.
The range of outcomes is extensive with an individual stock, especially if it’s considered a relatively young speculative company. This may have worked out great for you and why you have this large stock position! However, the closer you are to being dependent on your investments, the more likely you should diversify your position.
If you’re earlier in your career, maximizing the leverage of your stock options may be the right move, which leads me to the second factor.
2) The length of time until the stock options expire.
The longer the time until expiration, the more valuable the stock options are. Why? Because the time value of the options provide leverage for the shares to appreciate above the exercise price (the price at which you can purchase the shares).
The longer the time until expiration, the more likely you should hold off on diversifying your position (or exercising in general). Exercising sooner rather than later may make sense if you’re trying to benefit from long term capital gains. For ISOs, you need to hold the shares two years from the grant date and one year from the exercise date before selling to benefit from the lower long-term capital gains tax rate.
Taxes should be a secondary factor to “how close you are to solidifying financial independence” from a financial standing point.
However, let’s discuss the next factor, which, you guessed it, taxes!
This is the one you probably came for! It’s definitely a huge factor determining how fast to diversify a stock position (especially an option). I’m going to primarily discuss ISOs since they provide the most flexibility from a tax planning standpoint.
Let’s say you’ve determined a maximum percentage of your investable assets that you’re comfortable holding as an individual stock. If you’ve experienced a windfall, you’re probably going to need to exercise and sell a large portion of your employee stock options to get down to the percentage of a concentrated position you’ve determined you’re comfortable with.
The primary benefit to a buy and hold strategy after exercising stock options is to benefit from long term capital gains. Long term capital gains are taxed at a lower rate than your normal taxable income. The savings vary depending on your income tax rate, but the typical tax savings from achieving long term capital gains is ~15%.
However, said differently, if the share price of your stock option that you exercise and proceed to hold drops by 15% or more (over the holding period), you’ve lost the benefit of the LTCG rate. In which case, you would’ve been better off just exercising, selling immediately, and paying the higher short-term capital gain tax (taxed as regular income). Not to mention the opportunity cost of readily available investments like a diversified investment portfolio.
As you can see, the tax planning component gets complicated. Factor in the potential for the alternative minimum tax (AMT), and there can be many different paths and concerns from a cash flow and tax liability standpoint.
You should seek expert tax and financial planning advice if you don’t feel comfortable. These are large dollar decisions and are well worth your investment in an expert.
4) The in-the-money or intrinsic value of the stock options.
What is the current value of the options? This is determined by calculating the share price minus the exercise price multiplied by the number of vested options at your disposal. The more “in-the-money” your stock options are, the more likely diversifying is the right move, especially the closer you are to expiration.
If your options are “out-of-the-money,” then obviously you shouldn’t exercise, and you wouldn’t be reading this! 🙂
5) The expected volatility of the stock.
The more volatile the stock, the larger the range of potential outcomes. If you’re earlier in your career, you have the capacity to take on the risk of a speculative stock if you have the tolerance to stay disciplined. If you’re working in a start-up setting as a young professional, I’d argue you might as well take on the risk if you’re going to put material effort into helping build that business.
As someone who works for that company, you should have a better sense of its trajectory. That doesn’t mean you shouldn’t have a long term plan for diversifying if you experience a windfall.
6) The risk-free rate of return (your high yield savings account).
This means the rate of return for a risk-free investment like your high yield savings account. The risk-free rate is out of your control and dependent on the interest rate environment influenced by the economy and Federal Reserve.
The higher the risk-free rate of return, the higher the opportunity cost of holding onto a concentrated stock position that has risk.
7) Can you live with the potential FOMO in exchange for building towards solidifying your long term financial plan?
A successful long term investor has to become comfortable with the fear of missing out. What is investing FOMO? It’s the fear of watching your stock position that you’ve diversified continue to grow at a pace greater than the overall stock market.
It can be hard to watch in the short run, but in the long run, it’s usually the right decision as long as you’ve considered the factors discussed in this post.
If you’re concerned about FOMO, ask yourself the following question: “Would I go out of my way to have the company I work for represent this large a position of my investment portfolio if I didn’t work there”?
As always, successful investing mostly comes down to the psychological and behavioral aspects of decision making. We always want to do our best to devise a plan for avoiding major mistakes.
The video version of this blog post is available below:
Do you want to listen to the audio version of this blog post?
Click the following button to listen to the Do More With Your Money Podcast episode on your desired platform:
Connect with me on Twitter:
— are healthy
— have an emergency fund
— can pay your bills on time
— can choose how to use your time
— can invest for your financial future
You are one of the wealthiest people in the world.
— T.J. van Gerven (@TJvanGerven) October 15, 2020