Oct. 9, 2012— -- 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.
• Outcome bias. This causes investors to focus on past events, such as returns from a stock in recent years, rather than observing the events that created these outcomes and looking for differences. In the 1990s, people clung to the notion that past returns from tech stocks would continue indefinitely. But they ignored the high valuation bubble that this assumption had created and got stung when prices plummeted in 2000.
• Recency bias. This mind-set causes people to emphasize events of the recent past rather than those from long before. By believing that the future will likely resemble the recent past, they're seeking to defy the greater odds that the future will more likely resemble the long-term past average. This can cause an employee to ignore the fundamentals of his company and begin to chant the dangerous words "this time it's different" as they ignore historical facts about industry bubbles and peaks.
• Illusion-of-control bias. Some investors believe they can control outcomes when, of course, they can't. Employees who work hard to build a company are inclined to be concentrated in its stock whose fate they feel they control. Often that control proves illusory. In a capitalistic society we have seen the forces of competition wreak havoc on companies that many thought were safe and stable.
• Availability bias, or overestimating the likelihood of an outcome based on how familiar that outcome seems given the information that's available. Employees in a given industry are often focused on success stories and fail to look at companies in the same industry that fail. High-tech growth companies such as Google or Amazon are much more conspicuous than forgotten failures like webvan or etoys.
More recently, did employees of companies in the mercurial cell phone industry invest too heavily in their own company stock? This industry has over the years has seen a number of booms and busts and leadership seems to be ephemeral. Many of these companies have their day in the sun and as projections of the future become overly ambitious eventually the stocks come crashing down to earth like Icarus. If you were an employee of Apple you may feel like a genius today but what about the employees of Motorola, Research In Motion and Nokia? Didn't they used to have some of the hottest phones on the market?
Many of these people likely fell victim to recency or outcome bias--assuming that past successes would necessarily repeat.
The key is to open your mind to negative news concerning the stock you've loaded up on and stay objective. This negative news may end as a tsunami, but it doesn't start that way. It starts as one ripple after another. Savvy investors are attuned to these ripples, watching for the point where they turn into rising waves. Any winning portfolio contains losing stocks; it's the average performance that counts, relative to the weighting of different stocks.
So when you get ready to load up on your company stock, look inward to see if you are doing so out of behavioral bias. If your knowledge of the company or your identification with it were the same as it is for the typical stocks in your portfolio, would you be inclined to buy so much of it? If you've already pulled the trigger and bought a lot of this stock and it has been sliding for too long, be willing to admit that you're human.
Craig J. Coletta has 20 years of experience in the financial industry. He is president of C.J. Coletta & Co., a Registered Investment Advisor firm, and president of Coletta Investment Research Inc. Coletta is a Chartered Financial Analyst charterholder, a Chartered Market Technician and a Certified Hedge Fund Professional. He holds a B.S. in accounting and business administration from Rider University, and is a member of the American Institute of Certified Public Accountants.