Risk Ahead Photo by  Aleksandar Mijatovic on 123rf.comIMAGE: Aleksandar Mijatovic / 123rf.com

By John Lau, CPA, CFP

A heavy concentration in your company stock can be a double edged sword. If it keeps with its upward trend, you may feel like you are having a windfall of a portfolio; but say a worthy competitor enters the scene, or a new government regulation is enacted with an adverse effect on your company, your stock portfolio may immediately go into a nosedive. Your equity portfolio will respond to positive and negative forces, so stay guarded and manage risk accordingly. It isn’t whether you are right or wrong about holding on to your company stocks that is important, what is truly important is how much money you make when you’re right, and how much you lose when you’re wrong. Risk management is key to wealth building. Your company stock options are no exception.

A time tested risk management strategy is DIVERSIFICATION. In a nutshell, diversification is about spreading your risks around by not putting all your eggs in one basket. You would need to diversify not only with different company stocks, but also different asset classes. In the world of investments, there are six broad asset classes to pick from — U.S. (domestic) stocks, foreign stocks, commodities, foreign currencies, fixed-income securities (such as bonds), and cash. When a portfolio is spread between two or more asset classes, the force of negative correlation kicks in. When there is a market correction, not all asset classes react the same way, or to the same extent. While some asset classes may drop precipitously, another asset class may stay relatively level, or their values may even increase, acting sort of as a check and balance against one another. Diversification should be a key factor in deciding whether to exercise your options or not.

Another risk management strategy is the VALUATION factor. Is your company stock trading at unrealistic valuation, and is the valuation sustainable? Take Amazon stock (Nasdaq: AMZN). At the time of this writing, the stock is trading at $354.53 (Ycharts.com, 02/01/2015). This valuation commands a price-earnings ratio of 840.65. Price earnings ratio is a valuation ratio of a company’s current share price compared to its per-share earnings. This means at its current price, it will take eight hundred and forty plus years of earnings to break even. Now, compare this to the average PE ratios of the three most actively tracked indices as at January 30, 2015:

Dow Industrials16.35
S&P 50019.79
Nasdaq 10023.75

(Market Data Center: Wall Street Journal)

The overvaluation of the Amazon stock is unmistakable. Sure enough, Amazon stocks may very well continue to climb despite the overvaluation. Now the question is: do you want to take the risk of holding a large concentration of an overvalued stock?

I am far from suggesting that you should not hold a stock just because it has a high PE ratio. After all, PE ratio is only one of many valuation factors, and there are other factors to consider (such as product innovation, expected future earnings, etc.) but valuation is an important factor nonetheless. This brings me to the next risk management strategy – position sizing.

POSITION SIZING is all about how much of your company stock to hold in your portfolio. It is diversification quantified. Position sizing works in tandem with volatility to limit risk exposure to your total stock holdings. In addition to the valuation factor, consider your company stock’s volatility in order to determine the position size that the stock would represent in your diversified portfolio. A volatile share is one that has a tendency to move sharply through a wide share price range. In general, high volatility means high unpredictability, and therefore greater risk but also greater opportunity to make money. You can find your company’s volatility index in its annual report. Use that to establish a stop loss, which will allow the stock to grow while limiting its downside risk. Stop losses can help you determine the appropriate size of your position.

Let me illustrate…  Say your company stock has a volatility index of 35. This means it may swing up or down 35% from the current price. By setting a stop loss at 35% would provide the stock some wiggle room to grow within its normal range of fluctuation. But say if the stock price declines by 35% or more, the stop loss will be triggered, signaling time to sell. This will allow you to compute the position size for the stock. If you are willing to tolerate a potential loss exposure of, say 2% of total holdings, a 35% volatility index (or potential loss) would mean a 5.7% position size (so that a 35% loss on 5.7% of your total stock holdings would be approximately 2%).

Conclusions: Your employee stock options are an integral part of your personal wealth and managing their risk is both important and complex. A financial advisor who is knowledgeable and experienced with equity compensation will be able to provide you with guidance starting with a “Personal Equity Compensation Profile” analysis. This report will help determine when to exercise your options and build wealth in a risk managed diversified portfolio.

John Lau is the Managing Director of LFS Asset Management, a wealth management firm in San Mateo, CA. You may visit John’s company website at www.lfsfinance.com

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