The Patient Investor

Equity Compensation: Big Opportunity or Risk?

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.

 

 

The Patient Investor

Reflections on the Stock Market and My Career

As the Dow Jones Industrial Average reached 40,000 on May 16, 2024, I found myself reflecting on my career and what I’ve witnessed in the U.S. stock market over the last twenty plus years.

Note: The “Dow” or Dow Jones Industrial Average is an index comprised of 30 of the largest companies in the United States stock market (such as McDonalds, Apple, and 3M).

As one of the oldest market indices, the “Dow” is often used as a proxy for how the stock market is performing.

While we believe broad diversification is prudent for investors (and that’s a whole topic itself), I’ll be focusing on the U.S. stock market here.

I began my career at Piper Jaffray in early 2000. I had just finished an MBA from the University of St. Thomas and the investment world intrigued me. Over the last several years, the markets had gone through an explosive rally, driven by the promise of the internet. Technologies were seeing their stock prices skyrocket and it seemed like everybody was jumping on board. What an exciting time to start a career in the financial world!

In one of my prior blogs entitled “Would you have fired Warren Buffett?” I discussed how Buffett underperformed during this time with some investors questioning if he was too old fashioned. Some went so far as to fire him as their investment manager.

Unfortunately, my hiring coincided with the end of the party. In what’s become known as the “tech bubble,” stocks cratered and the tech-focused NASDAQ index fell 78%. That was my first lesson in the risk of failing to diversify and chasing past returns. When a certain investment or sector gets hot, I’ve seen that play repeat itself over the years in things like individual stocks, real estate, and cryptocurrency.

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The Patient Investor

Who Is the Media?

In the past, we’ve been known to take aim at the media. That’s because there may be consequences that are not beneficial to your personal wealth if you read, watch, or listen to too much news—or if you read too much into the news you’re reading.

It’s human nature to react to the onslaught of information with fits of fear, excitement, or confusion. These emotions, in turn, may lead to counterproductive, buy high/sell low investing.

Often, the media is partially to blame for this. They know what attracts our attention. They know this is rarely the evidence-based, sensible fare investors are better off digesting daily. Many members of the press choose to pander to our junk-news cravings and prioritize their own profits over a commitment to their craft. 

Let's return to our question: Who is "the media"? We’re happy to report that not every member of the financial press is cut from the same self-serving cloth. There are financial journalists who could get away with manipulating us, but they choose not to. By understanding the difference, you may find it easier to identify who within the financial press is worth following, and who you would be best advised to “unlike."

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The Patient Investor

Should You Depend on Dividend Stocks? Part 2: Dividend Stocks vs. Total Return Investing

In Part 1 of Should You Depend On Dividend Stocks? we described why dividend investing—or, buying up stocks known for attractive dividends—may not be an ideal strategy for generating a dependable income stream out of your investment portfolio.

In this blog, we’ll look at why we typically prefer a total return investment strategy over more concentrated dividend stock portfolios in many circumstances, including retirees who are drawing income out of their portfolios. Here are two questions for homing in on a more comprehensive way to build and spend your lifetime wealth:

1. Investing: As you invest and accumulate wealth over time, how can you pursue a potentially higher total return over time, given the level of market risk you can tolerate?

2. Divesting: As you take income out of your portfolio, how can you maintain its risk-managed structure, while generating tax-efficient withdrawals over time?

Where dividend investing can fall short on these pivotal counts, total return investing is structured to directly address them, head on.

How Does Total Return Investing Work?

Bottom line, there are essentially three ways any given investment can reward investors:

1. Interest/Dividends: A security can pay out more or less interest or dividends.

2. Capital Appreciation: A security can offer higher or lower capital gains or losses (based on how much you pay per share versus how much your shares are worth when you sell them).

3. Cost Control: As you buy and sell your holdings, you can incur more or fewer taxes and other costs that eat into your returns.

Instead of seeking to isolate and maximize dividends as a single solution, total-return investing seeks to make best use of all three of these potential money-making tools as they apply to you, your investment opportunities, and your personal financial goals.

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The Patient Investor

Should You Depend on Dividend Stocks?

There’s a popular perception that “dividend stocks,” stocks known for paying out consistent dividends, can deliver decent returns, while also creating a dependable income stream for spending in retirement or elsewhere. But is loading up on dividend stocks really such a good idea? Building a concentrated position in dividend stocks may be appealing at first glance, but a closer look reveals cracks in the foundation. First, let’s look at how dividend stocks deliver their returns. Next, let’s see why we prefer the total return approach of a more globally diversified investment portfolio, even when you’re spending down your investments in retirement.

More Dividends Equals Less Capital

One of the greatest misperceptions about stock dividends is that they represent “free” or “extra” money, beyond the capital value of the shares you hold. This free-dividend fallacy leads many investors to think of stocks as their “cake,” and dividends as an extra layer of frosting. However, this view is not true.

As University of Chicago’s Samuel Hartzmark explains:

“[I]f you have a stock that is worth $10 and it pays a dollar worth of dividend, the price goes to $9, and you’ve got a dollar worth of dividend. So, unlike the bond where, if it paid a certain coupon payment, you end up with more money, when you receive a dividend, you have the exact same amount of money, just labeled slightly differently.”

Think of it like this—dividends are a bite out of your cake. You might not notice a specific dividend-driven price drop, since market pricing mechanisms are always instantaneously adjusting share prices based on myriad factors. But it’s there. Post-dividend, your stock—your slice of a company—is worth a tiny bit less.

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