A common investing error is to own way too much stock of the company your work for. Not only does this practice ignore the principle of diversification — spreading your stock investments over a wide variety of industries and company sizes — but sets you up for potentially falling severely short of your reaching your retirement goals.
Yet many employees, including executives, load up on company stock and thus load up on risk. Should their company tank, an outsize piece of their portfolio in dollar terms goes down with it. In addition, if the firm goes bankrupt, the workers lose both their jobs and much of their retirement resources.
Executives may be even more inclined to go overboard than the rank and file because they're guiding the ship and feel they can see what is on the horizon. Often they are caught far out at sea when a storm approaches, clinging on as their net worth ends up at the bottom of the sea. These shareholders should seek safety by diversifying.
Market history is replete with examples of employees being far over-invested in their companies – and how this led to their downfall. The meteoric growth of Enron, propelled by concealed accounting fraud, prompted biased employees to buy shares aplenty, leading to their ruin when the company imploded in 2001. At the end of 2000, 62 percent of Enron employees' 401(k) plan assets were in Enron stock. By early in 2002, the company had fallen from $80 a share to going out of business. These employees got hit twice because they also lost their jobs.
Lehman Brothers' 401(k) plan was an example of extreme employee over-concentration in company stock. More than 10 percent of the plan's assets were in Lehman stock.
Technology companies have produced some incredible gains for some employees for snapshots in time, but many tech companies have fallen to the wayside or have never resumed their glory days. You can't control outcomes, but you can control your exposure to risk.
Many investors understand the value of diversification, but they over-invest in their companies' stock anyway. Why? The most common reason is that they're biased, and their biases provoke emotions that overrule logic and sound investment practice. Behavioral finance experts study investor behavior from a psychological standpoint, assessing motivations and reactions stemming not from logic, but from emotion.
They have identified various types of common biases that can lead to over-concentration in a single stock.
• Confirmation bias. Perhaps more than any other bias, this one can sink your portfolio ship. After purchasing a disproportionately large block of stock, investors afflicted with this bias tend to ignore or discount information that suggests this stock isn't a good investment. It's only human to want to be correct and to cling to the assumption that you were. Rosy predictions and buzz about a company are often the key focal points of employees as they ignore any negative comments. People seem to unduly emphasize any evidence that suggests their company will do well.