The Dangers of Loading Up On Company Stock

“If only I’d put all my money in Apple before they came out with the iPod.”

Have you ever caught yourself dreaming about hitting the jackpot with a stock you buy at a bargain basement price, only to see it soar to the moon?

When Warren Buffett took over Berkshire Hathaway back in the early 1960s, shares traded for about $11. A share purchased then would be worth over $190,000 today. If only …

But beware. There are dangers of loading up on too much company stock.

In this article, we’ll explain why you should be cautious — and how you should invest instead.

The Odds Are Not In Your Favor

Here’s the cold, hard truth: you are more likely to hit the jackpot at a Las Vegas roulette wheel than you are to find that one gem of a stock from among more than 5,000 publicly traded U.S. companies.

That means you’re not very likely to score the next Berkshire Hathaway.

Stock prices (more or less) reflect all known information that could reasonably have an impact on the company’s future cash flows. When Apple shares were trading at just above $3 in late 1997, nobody had any idea that the iPod, iPhone and iPad would each revolutionize the market for consumer electronics. Their potential impact on Apple’s future cash flows, in other words, was not known.

Who was to say that Apple would be the big winner of the next decade, and not Microsoft, or IBM? If you were right, you were right because of dumb luck.

Unnecessary Risks

But the problem isn’t just that you are very unlikely to pick the next Apple or Google. (In other words, the problem isn’t simply “unlikelihood of upside.”) The bigger issue is that concentrating too much of your portfolio in one company exposes you to unnecessary, avoidable risk.

In the financial textbooks this is called “business risk.” It is the component of risk associated with the peculiarities of an individual business, as opposed to the risk associated with investing in a particular sector (like utilities or health care) or in a broad investment category like U.S. large-cap equities or frontier markets.

Here are two clear examples of the pitfalls of business risk: Enron and Lehman Brothers.

For much of their respective histories as publicly traded companies, these two stocks were high flyers. But when the dust settled – in one case from a house-of-cards business model and in the other from an overleveraged bet on illiquid derivative securities – the shares of these two companies were worthless.

In 2008, if you invested in an S&P 500 ETF, you would have lost about 37% of your investment. If you invested in Lehman Brothers stock, you lost 100%. That’s the difference between market risk and business risk.

Company Stock: It’s Usually Your Company

Who were the really big losers in the Enron, Lehman Brothers and similar debacles? Mostly the employees of those companies, whose 401(k) plans were often top-heavy with the local brand.

Publicly traded companies often make it very easy for their employees to invest in their shares — while perhaps also implying that it would be a good sign of loyalty and confidence to do so.

Wrong. There are plenty of smart ways to show your confidence in your employer, but loading up on company stock is not one of them.

After all, you already draw a paycheck from this employer. You probably enjoy health benefits, paid vacation days, family leave time, and other perks. The company may be a pillar of your local community, creating local jobs that keep your town running and your home values steady.

So there are already lots of bad consequences in store if things go south for your employer. Don’t add to that risk by getting caught holding the bag in your portfolio as well.

Business Risk is Diversifiable

The good thing about business risk? You can get rid of it by diversifying into a large number of different stocks, preferably ones in different industry sectors, with different patterns of earning revenue and profits over the course of a business cycle. Financial theory generally maintains that by holding 20 or more diverse stocks, you are effectively diversifying away business risk.

Mutual funds — and later index funds and exchange-traded funds, or ETFs — became popular in large part because they come with built-in diversification. If you buy a large-cap U.S. equity mutual fund, you will tend to find a wide mix of companies across a diverse span of industries from basic manufacturing to insurance, healthcare to information technology, retail apparel chains to mining companies. If one company within that mix collapses, the other companies will mitigate those losses.

Asset Class Diversification

But don’t stop with a diversified mutual fund in one asset class. If you’re investing for a long-term goal like retirement, you need to divide your portfolio into different asset class slices.

Asset classes are groupings of assets with certain characteristics – for example, low price to book value (value stocks), large market capitalization (large cap stocks), reliable fixed interest coupon payments (investment grade bonds), or geographic regions (non-U.S. stocks and bonds).

How do you know which asset classes you should include in your portfolio? How do you know much to allocate to each class? Use an online portfolio management service like Jemstep.com, which provides unbiased, expert advice tailored specifically to your age, timeline, investment goals and risk considerations.

Is your 401(k) loaded with too much company stock? Let Jemstep show you how to reallocate that into other, more appropriate investments in diverse asset classes.

Hopefully your company won’t be the next Enron. But why take that risk?