How to diversify beyond
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By Sue Stevens, CFA, CFP, CPA | 01-10-02 | 06:00 AM | Email Article

If anyone had doubts about how detrimental company stock holdings can be to your overall wealth, Enron’s  debacle should make the picture crystal clear. Enron has topped the news in recent months with horror stories of how participants in the company retirement plan have watched their nest eggs plummet in value. Enron stock went from a 52-week high of $82.75 down to $0.25 per share.

Sue Stevens, CPA, CFP, MBA, and CFA Charterholder, runs her own financial planning firm, Stevens Portfolio Design, and manages over $100 million in assets.

Of course, company stock has also made lots of people millionaires. Just ask anyone who’s worked at Microsoft  for at least 10 years. But just remember: While the additional risk of one single stock may give you the potential for a higher upside, it can just as easily take you on a fast ride in the opposite direction from your long-awaited dreams.

If company stock is a part of your portfolio, it’s time to figure out how dependent you are and how you can diversify beyond it.

Owning Too Much of a Good Thing
Let’s look at the Microsoft example again. Sure there are a lot of people at Microsoft who have made their fortunes with Microsoft stock--through stock options, stock purchase plans, even Microsoft stock in their mutual funds and company retirement plan. But starting in January 2000 those employees watched Microsoft stock drop from $119.94 to $40.25 in less than one year. Those folks who weren’t diversified took a huge hit. Microsoft stock has recovered from that point, but it’s still not back to its peak levels. And not everyone will be that fortunate.

The double-whammy with company stock is that not only do you have your portfolio tied up in one stock in a single industry, but your human capital (your ability to earn a salary) is also tied up in the same basket. That’s bad news when companies respond to poor economic conditions by making layoffs, which have been all too common in the past year. Frequently those layoffs came when the company stock was not performing well. So in those cases, the pink slip not only meant no more regular employment, but a decrease in wealth due to stock options that were "under water" (the market price was less than the exercise price), retirement plans that had significantly decreased in value, etc.

How Much Do You Own?
Your company’s stock may appear in lots of different places and take a variety of different forms, such as:

  • In your 401(k) plan (Consider not only your contributions, but also your company match, if that match is made in company stock.)
  • In the form of vested stock options, which allow you to buy more of the company’s stock
  • In your taxable accounts, either directly or through mutual funds
  • In ESOP accounts, or tax-deferred retirement plans that are entirely funded with company stock

To see just how much of your company’s stock you own, enter your portfolio in Morningstar.com’s Portfolio Manager and click on "X-Ray this Portfolio." Take a look at the Stock Overlap report in the Views drop-down menu--that will give you an idea of how much of your overall portfolio is dedicated to your company’s stock. You may be surprised to find that your mutual funds own your company’s stock, too. (Note that the Stock Overlap report is a feature available only to Premium Members. For a free trial membership, click here.)

How Much Is Too Much?
Experts disagree on what the "proper" amount of company stock is. Some will say you should never own any company stock (see Mary Rowland's A Commonsense Guide to Your 401(k)). Others will tell you to limit your company-stock stake to no more than 30% of your portfolio (see The Lump Sum Advisor, by Anthony M. Gallea).

My advice is somewhere in the middle--generally no more than 10% of your portfolio should be in your company’s stock, especially if you plan to retire in less than five years. If that one stock has a bad streak right before you plan to retire, you may not be able to reach your goal.

Keep in mind that limiting your exposure to company stock is a defensive measure for your portfolio. There is always the possibility that your company stock will do better than a balanced portfolio of stocks and bonds. But that possibility comes with a much greater risk because of the concentration in one stock.

Tips For You
If you think you own too much company stock as a percentage of your portfolio, consider the following:

  • Those of you with five or more years until retirement can weigh your company's longer-term prospects. Morningstar can help you do that through our Stock Ratings, Stock Grades, and Analyst Reports.
  • Even if the prospects look bright, weigh all the risks of investing in your employer’s stock. If you are risk-averse, you’ll want to limit that risk to no more than 10% of your overall portfolio.
  • If you are overweighted in one style due to your company stock, try to use any assets held outside of your company to balance out your portfolio. So for example if you find your company stock overweights your portfolio in the large-growth style, invest your IRA or taxable accounts in international stocks or mid/small-cap value stocks. Consider bonds to further diversify your risk.
  • To reduce your exposure to your company’s stock, map out a plan. If you bought or received the shares at a very low price, you may owe significant capital-gains taxes on the growth of those shares if you held them in a taxable account. (Selling shares held in a tax-deferred account, such as a retirement plan or IRA, won't trigger any current taxes.) Consider selling your shares over a number of years to spread out those taxes over time. (For more on this subject, read "Strategies for Appreciated Investments".)
  • Even though there is a need to diversify your portfolio, especially before retirement, there is one other tax issue to consider that makes this decision even more confusing.

    You can get special tax treatment on those shares of company stock if you don't roll them over into an IRA at retirement. Instead, you can take a distribution "in-kind." In other words, you take the actual shares of stock--you don't sell them. You’ll pay ordinary income tax on the basis (the original price the company paid for that stock). If the value of the stock was $5 when you received your shares and they’re worth $25 today, you only pay ordinary income tax on the $5 when you take your in-kind distribution, not the current market value.

    When you eventually sell the shares, all appreciation over the original cost will be taxed at capital-gains rates. Your tax savings could be significant. Of course, you're taking on extra risk by holding that one individual stock and not diversifying into other assets.

No doubt we’ll see attempts at legislating how much company stock should be allowed to be held in company retirement accounts. The number of lawsuits by participants against their former employers is rising. But you don’t need to wait for that to happen--take a closer look at your portfolio today and make some changes. With some careful planning, you can control the risk of your company stock and help ensure a brighter future.

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Sue Stevens, CFA, CFP, CPA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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