By: AnnaMarie Mock, CFP®
I'm new to gardening as my interest in this hobby blossomed (pun intended) over the Covid lockdown. This spring, I was clearing out my garden in preparation for my new plants, and I spotted a patch of weeds that overtook about a quarter of usable soil within the garden confines.
When I started pulling out the vegetation, I began to smell a peppermint scent; not being phased, I continued my task of clearing it. Then suddenly, I realized this was the peppermint I planted last year on the outside permitter of my garden!
Being a novice gardener, I am not adept with the growth patterns and care for some plants. I had waited too long into the spring season to prep my garden, so I unintentionally let the peppermint plant overtake the space. Although I see value in having the peppermint plant because of its versatility, I only want it in the designated areas. I will need to periodically trim the plant to ensure it doesn't invade my garden again.
Equity Compensation and Over Concentration
Like the overgrown peppermint plant, when left on autopilot, equity compensation can also overtake your investable net worth and unintentionally expose you to significantly more risk. With increased uncertainty, markets become more volatile, and stock values can fluctuate up or down daily.
Managing Equity Compensation Example - Pharmaceutical Company
Let's use actual data from a global pharmaceutical company as an example. Over the years, you accumulate wealth in a diversified portfolio of $500,000 and 5,000 RSUs, restricted stock units, from annual awards.
We will assume that after 2014 there are no additional RSU awards, and you are not adding any additional principal to the diversified portfolio. There are many reasons why someone may not proactively manage their equity compensation like the following:
RSUs are not sold as they vest because the rules are so convoluted
No time to research the long-term incentive plan
No immediate need for the proceeds
Below is a chart of the stock price history of the global pharmaceutical company starting from May 2014. The stock ranges anywhere from $46 to $75 in 8 years.
The price movement can significantly impact your total wealth and the amount of concentration of one individual stock. Let's track the growth of the diversified portfolio compared to the stock.
In May 2014, the concentrated position of the pharmaceutical stock was 33% of total assets, with a stock price of $49.90. In 2015 and 2016, it grew to 37%-38% of assets and a new stock price of almost $72 per share; at that time, you may be pleased that you kept the stock but may not have realized it grew to a significant portion of your total assets. Over the next five years, the stock price decreases to a low of $46 per share and never breaks $66 per share again until 2022. The 38% concentration drops to 23% and hovers around the 27% mark in 2022.
It's advisable to cap concentrated stock to 10% of total investable net worth. As captured above, having excess exposure to one stock can be a roller coaster ride. Investors fear missing out on the upside but usually forget that there is a downside potential as well.
Diversification vs Over Concentration
Although the pharmaceutical stock grew over the years, would it have grown more in a diversified portfolio? The annualized return of a diversified portfolio was 9.56% compared to 8.54% for the concentrated stock position. The 1% difference may not seem material. However, the $250,000 RSUs would have grown to $532,000 compared to the $376,850.
Equity compensation is a tremendous benefit that can improve your likelihood of financial success and freedom. Diversification is not always straightforward when there may be brief trading windows to sell the stock, or sheer loyalty and confidence in the company makes it difficult to diversify wealth. However, no one has a crystal ball. It's easy to reflect on historical data because, as the adage goes - "hindsight is 20/20".
Everyone has different circumstances, and every company/ industry has different nuances and trends that can vary regularly. This is why we recommend working with an adviser to create a game plan for your stock options while keeping your long-term financial plan in mind.
The foregoing content reflects the opinions of Highland Financial Advisors, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct.
Individual security performance and diversified portfolio performance are not representative of the performance of Highland Financial Advisors or our clients. Future performance will vary and similar performance cannot be guaranteed.
Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.
AnnaMarie Mock is a CERTIFIED FINANCIAL PLANNER™ and Partner at HIGHLAND Financial Advisors, LLC, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, employer retirement planning, and investment management. AnnaMarie graduated from Montclair State University with a degree in finance and management and successfully passed the CFP® national exam in 2016. She has been working at Highland Financial Advisors since 2013 as a fee-only, fiduciary Wealth Advisor and is a member of NAPFA.