You have probably heard about the importance of diversifying your investment portfolio i.e. not putting all your eggs in one basket.  What follows is a brief narrative of Elan Pharmaceuticals, where I formerly worked as a research scientist. I learned a valuable lesson about diversification, and hope you can benefit from this example.  Imagine watching your company stock increase steadily in value, and then drop in price from $60 to $1!  This post will give you a perspective on the implications of a concentrated stock position, discuss reasons why it may be hard to diversify, and present strategies for preserving your finances.

Concentrated Stock Positions and You

You have a concentrated position if stock from a single company makes up 5% or more of your investment portfolio (or net worth).  If that is the case, and the company drops in value, you may sustain serious financial losses.

You may have a concentrated position if:

• you work at a biotech company or high-tech company and have a long-term incentive plan
• you have company stock in your 401(k) plan  (think Enron employees; movie recommendation: Enron: The Smartest Guys in the Room)
• you inherit stock

This post focuses mainly on those who have obtained company stock through their long-term incentive plan (i.e. they exercised vested options or their restricted stock has vested).  In addition, your company is publicly traded and you are able to sell stock.

I Know My Company What Can Go Wrong?

Elan Pharmaceuticals at one point had very bright prospects.  From a research perspective, the company had developed a promising treatment for multiple sclerosis and was working on multiple strategies for treatment of Alzheimers disease.  I worked there during the golden period (1989-2001), when stock price steadily increased (from less than $10/share to about $60/share).

Its hard to convey the level of exuberance during that period, both because of the positive impact the company might have on some very serious diseases and the potential for personal gain. OK, Ill try.  Imagine if you worked at Google, and had been there for a couple of years.  In the graph below, there is the same upward trajectory in Google stock price.  I dont personally know any Google employees, but I can imagine how excited they must be.  BTW, I do not mean to imply that Google stock price is destined for the same fate as Elan.  However, there is uncertainty with any company, no matter how bright the current outlook may be.

Going back to my own personal experience, Elan stock price sustained three major drops. Around 2002, the price plummeted 90%, due to a combination of factors including the dot.com bust and allegations of accounting fraud.  Elan stock plunged again around 2005 and 2008, as a result of toxicity issues with their drug for multiple sclerosis.

So, how did I fare at Elan with employee stock options?  The blog title Smart but Clueless About Money aptly described me during this period.  The only reason I made substantial gains is that I left Elan in 2001, had 90 days to exercise options, and then sold (at around $60).  I guarantee you that had I stayed at Elan, I would have ridden the stock down to the bottom (as was the case for many employees).

The message for those of you with long-term incentive plans is that there are black swan events (rare but devastating).  I have heard people object and say that they know when there will be  a development, and they will get out in time.  If you are in upper management and are privy to company news prior to public disclosure, it is illegal for you to trade on this knowledge (i.e. insider trading).  If you work in the trenches, by the time you see the stock price start dropping, it may too late.

What Makes it Hard to Sell Your Company Stock?

• You think that your company is special (as described above).
• You are greedy.  You would hate to sell, and then watch the stock price keep going up.
• You are not sure how to invest proceeds from the sale of company stock.
• You feel disloyal to your company if you sell stock.
• You want to hold onto the stock for at least a year, so you can minimize taxes when selling by benefiting from the long-term capital gains tax rate.

Have I left anything out?  Feel free to post additional considerations.

Tips to Help You Benefit from Your Company Stock

1. Be aware of your company stock position by maintaining a spreadsheet of your exercised options/vested restricted stock.
2. Know how much your company stock contributes to your net worth.  The more substantial the component, the more pressing the need for diversification.
3. Be open to the possibility of volatility in your company stock, even though it looks like a winner right now.
4. Set financial goals for proceeds from sale of company stock.   If your goals are near-term (down payment for home, for example), it is important to sell and invest in cash equivalents (money market, CDs).
5. Dont second-guess yourself when selling stock.  If it goes up in price after you have sold, you still have made a profit.  And if you reinvest those funds in a diversified portfolio, you may still see an increase in value (depending on performance of stock market).
6. If you are reluctant to sell because you are uncertain on how to invest the money, get help.   There are excellent resources online for DIY investors (Vanguards website, for example), or hire someone to help you.  The Financial Planning Association has a searchable directory of financial planners.
7. If you are worried about feeling disloyal selling company stock, remember that companies routinely lay people off to maintain profitability.  It is up to you to look out for yourself.
8. Minimizing tax liability is not a sufficient reason to hold onto company stock.  Long-term capital gains are taxed at a more favorable rate, but there is no guarantee that company stock price will stay high during that one year holding period.
9. Plan for taxes owed prior to selling company stock, and set aside money to pay the IRS.

In addition to these basic recommendations, there are ways to manage the sale of your stock (stop-loss and stop-limit orders) and hedging strategies which are beyond the scope of this post.