by Phil DeMuth, Ph.D.

An excerpt from The Affluent Investor – Financial Advice to Grow and Protect Your Wealth

Today’s corporate executives should spend at least as much care considering how to manage his stock options and restricted stock as he does managing his airline miles. This is a daunting task, because the interwoven tax and investment issues are baffling. For this reason, most employees use their options as play money and execute them either when they want cash to buy something or when they see everyone else executing theirs because the stock price has been high lately. You can do better.

The idea is to maximize your lifetime wealth (return) while minimizing regret (risk). You don’t want to be the guy who exercised his options for pennies when the IPO would have made him a multimillionaire, but you also don’t want to be the guy who hung on to his company stock until it got delisted and now faces a six-figure tax liability with an empty checkbook. While the permutations go far beyond the scope of this book, here are some factors that impinge:

  • Read your own employee stock option agreement. Do not presume your deal is just like anyone else’s. Circle the passage where it mentions your options’ expiration dates. You don’t want to be one of the million employees Fidelity uncovered who let their in-the-money options expire.
  • There are two components making up the total value of your options: their intrinsic value and their time value. Their total value is what you get from a Black-Scholes calculator. Their intrinsic value is the difference between your strike price and the stock’s current price. The time value is the difference between the option’s intrinsic value and its total value. You don’t want to execute your options when they still have a lot of gas left in the tank in the form of time value. For guidance here, I commend to your attention the reports available from www.stockopter.com. These can form the foundation for a useful discussion with your advisor and CPA prior to making any moves.
  • The more volatile the stock, the closer you are to retirement, the less bullish you are on the stock, and the more of your net worth is concentrated in it, the sooner you should exercise.
  • It makes no sense to exercise non-qualified stock options and then hold the stock. You are already over-invested in your company through your human capital. Exercise, sell, and diversify.

Employee stock and stock options need to be considered in the context of your entire portfolio and not set to one side as if they didn’t exist. I like the Quantext QPP Monte Carlo Simulator (www.quantext.com) for advisors as well as savvy do-it-yourselfers. This Excel-based tool will let you experiment with changing the mix in your outside portfolio to compensate for the distortions of a concentrated holding, including your stock options. The aim is to tune down the idiosyncratic risk and create a version of your personal fund.

 

Phil DeMuth, Ph.D. is an author, psychologist, and Managing Director of Conservative Wealth Management LLC, an investment advisor to high-net-worth individuals. Phil’s articles have appeared in Barron’s, The Wall Street Journal, The Journal of Financial Planning and many other publications. He has made TV appearances on the various CNBC shows, Forbes on Fox, and Wall Street Week with Fortune. Phil has also co-authored seven books with Ben Stein on topics such as retirement planning, income investing, portfolio management, and alternative investments.

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