We all like hearing that we’re good at our jobs. It’s nice when kudos from your employer come bundled with dollar signs. At times, a company may value you so much that it offers you a piece of the pie in the form of equity compensation.

A small slice of equity compensation can give you a meaningful boost in your income. A bigger slice might offer a more significant—maybe even life-changing—financial windfall. Or not. Luck plays an important role. But it’s also important to manage your equity compensation by balancing its potential risks and rewards. Understanding the details of your equity stake and how it fits in with your overall financial plan can help you make the most of this added compensation. Moreover, doing so can help you avoid dangers such as concentration risk—the risk that too much of your wealth is tied up in a single stock.

Equity Compensation Basics

Equity compensation can come in lots of different forms. You might receive stock options, restricted stock units, or the ability to participate in an employee stock purchase plan. Your equity package might come with a vesting schedule, which determines how quickly you can take ownership of your shares. These vesting schedules accomplish an important goal for companies: They help keep you around longer.

Each part of your equity compensation package—from vesting rules to the types of shares you might receive—comes with a slew of caveats and fine print that are important to understand. For instance, your stock options might come with an expiration date for exercising those shares. If you miss that date, you may miss out on the opportunity to acquire company stock at a deep discount. (If the share price fails to rise to the occasion, with no discount available, you may intentionally let them expire unexercised.) There also are tax implications for your equity compensation: Understanding the ins and outs of your agreement can help you manage your tax burden and let you keep more of the equity you’ve worked so hard for.

In short, it makes sense to become familiar with the contours of your equity compensation offer. But fortunately, you don’t need to become an expert in its every nuance to make the most of the opportunity. Your financial advisor can help you integrate the package within your larger financial goals and collaborate with other available resources. Your company’s HR department or benefits administrator may be able to give you helpful information. Your accountant can weigh in on issues such as taxes, and a lawyer can help you decipher your agreement’s legal jargon and factor that equity compensation into your long-term estate plan.

Understanding the Risks of Equity Compensation

One downside of equity compensation is that it can tie up a large portion of your wealth in a single stock— known as concentration risk.

Not all risk is bad. In fact, a foundational part of investing is taking on risk in exchange for potentially higher returns. This type is called systemic risk—the risk inherent in the financial markets at large. However, concentration risk typically doesn’t reward you in the same way. Yes, there’s the long-shot potential for that single company to perform extraordinarily well and drive up the value of its stock. But unlike the systemic risks of investing in the stock market, concentration risk also means your wealth is closely tied to one company’s performance—and if that performance is poor, it can spell trouble for you.

Every company faces a litany of idiosyncratic risks. For instance, a scandal might taint its brand or even plunge it into dire financial straits, or its business could be irreparably disrupted by an upstart competitor. If the company’s stock price falls, your concentrated portfolio will follow suit.

Relying on your employer for your income and long-term savings can put you in a precarious position. If your company performs poorly, you could end up on the losing end of a corporate reorganization. Suddenly, a significant component of your wealth is in freefall, and your primary source of income has dried up.

Consider this example: In 2020, due to the pandemic, ride-hailing company stock prices tended to lose value as ridership plummeted. Some of these companies laid off thousands of workers. Employees who also held equity compensation stood to lose not only their paychecks but also a chunk of their potential personal wealth at the same time.

Finally, holding concentrated stock positions is speculative by nature — a de facto form of stock picking. The odds you’ll pick a stock that will outperform the broader market are low. It’s incredibly tough for professionals to do despite access to vast amounts of data. Consider that 60% of actively managed large-cap U.S. equity funds failed to beat the S&P 500 in 2023. There is an opportunity cost in remaining in a concentrated investment because it can keep you from sharing in the gains of a broader stock market rally.

“But,” you may counter, “I know my own company, and I’m confident its future is bright.” This reaction is common — and may be a sign you’re falling into a common behavioral tendency known as familiarity bias. It can lead you to the false assumption that your own company is safer or more of a sure thing than other companies. The fact is, your familiarity may actually be keeping you from making a level-headed investment decision. Instead, lean on objective data and research rather than feelings to inform your investment decisions.

Solving Concentration Risk

You can minimize concentration risk through diversification, carefully divesting company shares, and investing in broad market funds. Holding large swaths of the market helps smooth out the effects of volatility, maximize long-term returns, and manage systemic risks while dampening unnecessary idiosyncratic risk.

Whatever your equity compensation package looks like, you don’t have to navigate its complexities alone. Reach out to your financial advisor to discuss your options.

Stay patient, my friends.

Learn more about Eric Hutchens

Hello! I’m Eric, the president and chief investment officer at Allodium Investment Consultants, located in Minneapolis, MN. I am dedicated to helping clients achieve their unique goals through designing tax-efficient investment strategies and comprehensive financial planning.  In my spare time away from the office, I enjoy relaxing at my cabin in northwest Wisconsin with my wife, two sons, and two rescue dogs. I have also volunteered with my church, serving on the elder board and as a youth group leader.

The information provided is for educational purposes only and is not intended to be, and should not be construed as, investment, legal or tax advice. Allodium makes no warranties with regard to the information or results obtained by its use and disclaim any liability arising out of your use of or reliance on the information. It should not be construed as an offer, solicitation or recommendation to make an investment. The information is subject to change and, although based upon information that Allodium considers reliable, is not guaranteed as to accuracy or completeness. Past performance is not a guarantee or a predictor of future results of either the indices or any particular investment.