Today in the world of employee retirement plans, many people who work for publicly traded companies are being offered the chance to purchase their company's stock. A lot of employees choose this option, but it has benefits and drawbacks that differ from investing elsewhere. Read on to find out what you can expect if you invest in the company that employs you.
The Pros of Investing in Company Stock
Investing in your employer's stock has some distinct advantages:
- Higher Returns
When you are investing in company stock you will often receive matching contributions from your employer or a discount in relation to the market price of the stock. This means that your overall amount of ownership increases with the same amount of money and you will be able to see higher rewards as the price of the stock appreciates. Combine this with the fact that you can purchase shares at a discount, and the chance to see a higher return looks even more enticing.
- Better Knowledge of the Company
Another advantage of investing in company stock is that you typically have more knowledge than the average investor of the company, its business model and potential growth prospects. By having more knowledge of how the business works, employees may have more visibility about where the company's headed.
The Cons of Investing in Company Stock:
To determine whether investing in company stock is right for you it is important to also examine some of the drawbacks. These include:
- Lack of Diversification
When you are investing in company stock and your employer is matching your contributions or provide discount, this increases your overall ownership with the same amount of money in the company. While this may be a good thing at times, it can also mean that you are losing diversification if you allocate a large portion of your savings to company stock. If the company is not doing well, this means that your portfolio could see deeper downward swings, affecting the overall growth.
- Greater Risk
By owning a larger amount of the company stock, you could also experience greater risk. News may come out that is not favorable to the company and cause a serious decline in the stock. At the same time, since the company is suffering from financial troubles, they might cut down costs and lay off some employees. You might have to face the risk of both unemployment or a decline in the stock. This kind of volatility will no doubt play a role in how you will plan for retirement.
How Much Is Too Much?
While you want to be able to participate in the upside, it is also important to keep some kind of balance so that if the company stock does decline for whatever reason, you will be protected. An example of a good way to balance leverage and risk is as follows:
The 10% Guideline
As an employee, the maximum amount that you would want to invest in your company stock is no more than 10% of your overall portfolio - and even 10% might be too much risk for most. Keep in mind that most professional money managers rarely invest more than 5% in any individual company.
That being said, some common sense should be applied. If you are closer to retirement or any other time when you will need the money, you may want to reduce your allocation even more. In doing so, you are reducing your risk by keeping only a certain amount of your portfolio invested in company stock and then reducing the amount that you own as you move closer to the time that you will need the money.
There are many good reasons why you want to keep your ownership in company stock at low levels. One of the most regrettable situations involving company stocks is what happened to the employees of both Enron and WorldCom. Here were two large companies that had 401(k) plans and matching stock purchase plans for many of their employees. What the employees didn't know was that management was lying to their employees, investors and the public about the company's finances. Once the news was out, most of these employees were unable to sell their stock which continued to collapse. By the time both companies went bankrupt, many employees had lost their life savings because they had so much invested in the company's stock.
While what happened with Enron and WorldCom are unfortunate incidents, you can learn from the mistakes of others to protect yourself:
- Seek Out 401(k) Investment Options
In most 401(k)s there are a wide variety of investment choices available to you besides company stock. Oftentimes you will be able to invest in different mutual funds, bond funds or even annuities. Do your homework and ask some basic question so that you can make sure that your 401(k) is always protected.
- Set Up an IRA or Roth IRA
Another option is to invest in company stock with your 401(k) and then set up an IRA or Roth IRA. This will allow you to invest in other areas that you might not be able to with your 401(k) plan, thus helping to give your portfolio diversification.
The Bottom Line
Investing in company stock can be very advantageous, particularly if your employer matches what you invest in company stock. However, this kind of investing does have its drawbacks. As such, it is advisable to keep no more than 10% of your portfolio invested in company stock. If you are close to a time when you will need the money, you should reduce this amount to 5%. This will protect you should your company's stock prove less than satisfactory.
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