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Friday, 28 November 2014

Chesapeake lessons: Don't invest where you earn

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Like all massive risks, holding large amounts of stock in your employer is a way to make an investment home run, but an even better way to strike out.

James Saft, Reuters Columnist

The sad tale of Chesapeake Energy employees is a reminder of a series of oft taught but seldom learned lessons, namely that when you hold too much of your employer’s stock you imperil your retirement, impair your ability to manage risk and set yourself up for expensive, emotionally driven investment decisions.

A massive 38 percent of Chesapeake’s main 401(k) retirement plan’s assets were in company stock, despite only 5 percent of those assets still being tied up in a vesting period.

It is no wonder that employees jumped at a generous offer to match, dollar-for-dollar, the first 15 percent of their salary with shares of stock. What makes a heck of a lot less sense is why they held on to them after they were free to diversify.

While this has been a bit of a disaster for employees, as Chesapeake shares have fallen by nearly half, I’d argue holding more than 5 percent of your financial assets in your employer’s stock is bad policy whatever the returns and no matter how well run the company.

Considering that 9 percent of total 401(k) assets were still invested in company shares in 2009, according to the Employee Benefit Research Institute – and many accounts hold no company shares, thus implying greater concentration among those who do – this clearly is a message some people just don’t want to hear.

TAKE THE MONEY AND RUN

This is not to say that you shouldn’t avail yourself of matching funds if the cost of doing so is holding shares in your employer. Do, but cut back your holding as soon as you are allowed, no matter how tasty the Kool-Aid about your company’s bright future may be.

As an employee you already are hugely exposed to your company’s future, so holding lots of company stock represents an unacceptable risk.

Companies whose stocks fall sharply have a distressing tendency to lay people off – and vice versa. You could easily see your retirement or other assets dwindle just as your income falls off a cliff. As well, many people who get laid off find their career capital is worth much less on the open market than it was within an organization, meaning that when they do become re-employed it is at a lower salary.

Of course, some people get rich by holding nothing but shares in their employers, but there are also many, probably many more, who work for Lehman Brothers or Enron and see their portfolios turn to dust.

Diversification is basically the single best tool any investor has: it is reliable, it is cheap, and it unquestionably improves outcomes. Use it.

TAKE YOUR LOSSES

The other great lesson out of this is that grown-up investors take losses. If you have been foolish and held lots of your company’s stock and now it is tumbling, for heaven’s sake, don’t just stand there wishing it back up again. Sell some and cut risk.

All investors have a tendency to become psychologically attached to the top market value of their shares, and many confuse the plans and fantasies they hatch based on those values for promises. The universe does not care what your 401(k) used to be worth. Don’t wait for the rebound.

PERSPECTIVE MATTERS

Another reason to avoid holding too much of your employer’s stock is our natural tendency to let our emotional connection to a company get in the way of rational decision-making. No one can fairly evaluate their own children or the company to which they devote most of their waking hours.

This is a version of the endowment effect, a phenomenon described by James Montier of investment management firm GMO. People tend to demand more in payment for something they own than they would be willing to pay for it themselves, endowing it with a special value simply because it is associated with them. This is a classic mistake in the housing market, where people expect to get top dollar for a tired house simply because they raised a family there.

So it often is with employers. People simply don’t have the perspective they need to make good judgments. That’s a really useful attitude to have in forming a community or making a company successful, but check your endowment at the door when you visit your wealth manager.

When we know there is a good chance we are laboring under a behavioral fallacy, the best thing to do is impose a rule on yourself and follow it.

Simply put, don’t hold more than 5 percent of your financial assets in any security, especially if you happen to work for the company which issued it.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. To contact him by email: jamessaft@jamessaft.com)


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