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Morningstar.com's Interactive Classroom

Course 207
Investing in Your Company's Stock

Introduction

You always root for the home team. Or you only buy cars that are manufactured in the United States. Or you'd pass up World Series tickets for your nephew's third birthday party, because family is family.

Loyalty is powerful. But when it comes to investing, loyalty should have its limits, especially when it comes to investing in the stock of the company that you work for.

Here's why it's a bad idea to invest too much in your company's stock, how to figure out how much of your company's stock you already own, and how to prevent your portfolio from becoming too dependent on your company's stock.

When Loyalty Goes Too Far

Owning a stake in your company is a great idea--when your company is doing well. In fact, if you acquire stock when your company is still small, the returns can be astronomical. Also, instead of just being an employee, you're an owner, too. You have a personal stake in the company's growth and success.

But don't bet on becoming a millionaire with your company's stock. Bubbles burst. Just look at what happened to so many dot-com companies in 2000. Start-up companies with no profits aren't the only ones that are vulnerable. In the last 20 years, history has provided plenty of examples:

Take IBM IBM after the stock-market crash in 1987. Employees saw the value of their shares drop by two thirds. A lot of dreams--like sending children to college and retiring early--went up in smoke. Then there was Microsoft MSFT in 2000. The stock dropped from about $120 to under $50 at one point. Employees who failed to diversify their Microsoft-laden portfolios were wishing they had.

Finally, there's the story of the former employees of Color Tile. Not only did they lose their jobs when the company filed for bankruptcy in 1991, but because the company had funneled employees' retirement savings into Color Tile stock, a sizable portion of their retirement portfolios evaporated when their jobs disappeared.

As part of the 1997 Taxpayer Relief Act, employers can no longer direct more than 10% of their employees' retirement-plan contributions into company stock, as Color Tile did. But investors are still free to invest in the company stock without limit, and employers aren't restricted from matching employee contributions with company stock.

Simply put, overinvesting in your company's stock puts more of your financial eggs in one basket. Your employer's fortunes already dominate your present financial security. (Unless you're lucky enough to have a trust fund, it's pretty likely that you're relying almost exclusively on your employer for your current income.) Don't let them dominate your future goals, too.

How Much Do You Own?

Your company's stock may appear in a variety of different places and take a variety of different forms:

  • In your employer-sponsored retirement plan. Here, consider not only your purchases, 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, if your company's stock is publicly traded.

To see just how much of your company's stock you own, you'll need to determine what you own directly and what you own indirectly via your mutual funds. You could scour annual and semiannual reports for that information, then do the math to find out how much of your company's stock you actually own.

An alternative for Morningstar.com Premium Members is to enter their portfolios in Morningstar.com's Portfolio Manager and click on the "X-Ray" tab. Then, take a look at the Stock Intersection report--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. (Nonmembers can sign up for a free trial of Morningstar.com's Premium service.)

How Much Is Too Much?

Experts disagree on what the "proper" amount of company stock is. Some will say you should never own any of your company's stock at all. Others will tell you to limit your company-stock stake to no more than 30% of your portfolio.

While every investor's case is different, we prefer moderation. In general, no more than 10% of your portfolio should be in your company's stock, especially if your goal is less than five years away. If that one stock has a bad streak right before you need the money, you may not be able to reach your goal.

Let's take an example. Say you want to retire at age 62 with a $1,250,000 portfolio. You figure you can live on $50,000 a year from that nest egg. Five years before you retire, you have 10% of that portfolio (or $85,000) invested in your company's stock and 90% (or $765,000) in a well-balanced portfolio of stocks and bonds that you expect to grow at about 8% per year.

Then say the company stock tanks, losing 20% each year for five straight years. Your $85,000 investment in company stock drops to $27,850. At the end of five years, your portfolio is worth $1,151,850--not quite what you need, but not bad. If you had 30% of your portfolio in company stock, however, you might need to work an additional three years to make up those lost dollars.

Of course, there is always a chance your company stock will do better than a balanced portfolio. If that happens, having 30% of your portfolio in the stock might allow you to retire a few years early. Remember, limiting your exposure to company stock is a defensive measure for your portfolio

What If I Have Too Much?

If you find that you're over-invested in your company, consider the following:

1. If your goal for this money is more than five years away, weigh your company's longer-term prospects. Analyze your company as an investment. To learn how to do that, take a few courses in the Stocks curriculum. If your company's stock is public, you can find out more about your company using Morningstar.com's Stock Reports.

2. Even if the prospects look bright, weigh all the risks we've covered about investing in your employer's stock. Most people will want to limit that risk, but some may choose to accept a higher degree of risk for the potential payoff.

3. If you decide that you need to reduce your exposure to your company's stock, you'll need to 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 hold them in a taxable account. (Selling shares held in a tax-deferred account such as a retirement plan or IRA won't trigger any taxes.)

You can either take the tax hit all at once, because you can't handle the risk. Or you can take the risk and continue to hold the shares, because you know the taxes will kill you. The best choice for many, however, may be selling your shares over a series of years to spread out the tax bill.

Quiz 207
There is only one correct answer to each question.

1 What's wrong with owning a lot of your company's stock?
a. Nothing at all; if you own a lot of company stock, you're loyal.
b. You're putting both your present and your future financial security in your employer's hands.
c. You're bound to lose money.
2 Where are all the places your company's stock might appear, if its shares are publicly traded?
a. In your 401(k) plan
b. In your 401(k) plan and in the form of stock options
c. In your 401(k) plan, in the form of stock options, and in your mutual funds
3 If your goal is less than five years away, how much of their company's stock should most investors own at most?
a. None
b. 10%
c. 30%
4 If you find that you're over-invested in your company and your goal is more than five years away, what should you do?
a. Objectively analyze your company's stock as you would any other investment and determine whether or not you should scale back your position.
b. Do nothing--you have long enough to make up for any problems with the stock.
c. Sell immediately.
5 If you decide to sell some of your company stock but will owe significant capital-gains taxes on the growth of those shares, what should most investors do?
a. Sell it all. The tax headaches are nothing compared with the risk of keeping the shares.
b. Keep it all. The taxes will be a killer.
c. Sell the shares over a series of years to spread out the tax hit.
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