Welcome to Episode 23 of Retire Me
In today's episode we will discuss the best way to treat your employee stock options when planning for your retirement. We are also continuing our series: Key Questions for the Long Term Investor. This week we tackle question 7 which is: Will Frequent Changes in my Investment Portfolio help me achieve investment success?
What To Do With My Stock Options?
Stock options and their close cousin, Restricted Stock Units or RSU's, are common forms of compensation in growth industries like information technology.
The benefits of stock options and RSU's are two-fold
- for employers who are in high-growth phase, they can offer stock compensation as a stand in for higher base salaries
- For employees, you can share in the successes of the company if the company does well and the stock presumably goes up
In the situation where the company you work for his highly successful, it is common for employees to have high concentrations of their invested net worth in the stock of the company that they work for.
But, at a high level:
- When RSU's vest, the full value of the RSU award is taxed as regular income. The employer will typically withhold tax from the RSU award and deposit the balance of vested shares into a brokerage account that will continue to hold the shares on an ongoing basis. All future gains (and losses) are treated as regular shares would be (potential for capital gains and losses)
- When Options vest, employees have the option (but not the obligation) to exercise their options and purchase the option shares. They will only do this if the market value of the shares is higher than the strike price. For example, if the exercise price of a share is $10, and the share is worth $30 at the time the option vests, the option would be "in the money" and would purchase the shares from her employer for $10. They would realize income of $20 per share on the purchase. There is potential to recover 50% of that income via the security option deduction. Following the exercise, the purchased shares can be held in a brokerage account, and all future gains/losses are treated as regular shares would be (potential for capital gains/losses)
There are a lucky few out there who manage to accumulate very large amounts of their employers stock through obtaining grants over many years of employment with their firm. It is also helped if the company has been very successful (or promises to be very successful) and the price of that company's stock has gone up significantly. It is common (and I have seen it several times) where a persons invested net worth is primarily in the stock of their employer.
This puts people in a difficult position where they are now sitting on a very very concentrated position in their portfolio.
The advice I give to clients is threefold, PARTICULARLY for clients closing in on retirement:
- Have a financial plan and know what it will take for you to meet your financial goals
- Set aside enough of your stock option/RSU grant money to set yourself up to accomplish your financial goals
- Once you have done that, if you want to hold onto additional stock and absorb the risk that the value of the stock could go down dramatically, at least you have taken care of yourself first
While most people accept that this advice is reasonable and sensible, it is difficult to make this decision, especially if you have seen the value of your company stock double/triple/ or even more over the recent past. Ben Felix wrote an excellent article in the Globe and Mail in 2018, which outlines some of the known mental biases that we encounter when making decisions. He overlaid these biases onto the decision to hold or sell company stock. Being aware of some of these biases might help with your decision making.
- Regret aversion: Employees will often fear missing out on future gains if they exercise their options. (FOMO)
- Illusion of control: Employees may feel that their actions at work will have a direct impact on the share price.
- Optimism: People in general tend to believe that they are less likely than others to be subject to negative outcomes.
- Mental accounting: Employees will often treat their stock options as distinct from their other assets. It may help to think about the dollar value of your vested options and ask yourself: If I had that cash in my hands right now, would I use that cash to purchase shares in your employer as opposed to buying index funds or paying down your mortgage?
- Anchoring: Employees who watch their company’s share price may become anchored at a recent high price and feel unwilling to sell their shares for less.
So, if you hold a large position in your company's stock, first of all CONGRATULATIONS!! Getting large grants of company stock are like a super-charger for achieving your financial goals. But, be sure to keep an eye on your financial plan and make sure you're on track to achieve your financial goals before holding too much of your wealth in your company's stock
Key Questions for the Long Term Investor - Question 7 - Will Frequent Changes in my Investment Portfolio help me achieve investment success?
Many people think they need to predict where prices are going to get ahead, but this is not required to outperform markets.
How many times have you been stuck in traffic and switched to a faster lane only to come to a standstill? Doing this adds anxiety to your drive, it increases the risk of an accident, and you may or may not have improved your situation.
Of all of the investment mistakes, I believe this is the one that does in even the most disciplined investors. It is best known as "market timing" Trying to time out which investment or asset class is going to do best over the next short time clip.
The main three ways that I see this manifested with investors are:
- The desire to "go to the sidelines until the dust settles"
- Investing in gold
- Holding cash for long periods of time, waiting for the next dip
I am going to cover the influence of media in next week's episode, but I think that people can mostly be forgiven for having these emotions. After all - this is what is being pumped at us day in and day out by the financial news outlets (ie. "here's whats going to happen next!", "what to do to get ready for the next downturn", etc.).
Likely the best market timing quote comes from Peter Lynch, who ran the Fidelity Magellan fund in the 80's:
"I can't recall ever once having seen the name of a market timer on Forbes' annual list of the richest people in the world. If it were truly possible to predict corrections, you'd think somebody would have made billions by doing it." - Peter Lynch
Refer to the following chart from Dimensional Fund Advisors
As you can see, the performance of different asset classes is mostly random from year to year. The only reliable way to capture the returns of stocks and bonds is to hold them in steady proportions and rebalance. Trying to time out which asset class will do best from quarter to quarter and year to year is a reliable way to lose money historically. The best course is to diversify across asset classes, and do nothing for as long as possible.
Have a great week!
Disclaimer - This podcast is for informational purposes only. Please consult with a financial advisor familiar with your unique financial situation before making any decisions. Nothing in this broadcast constitutes a solicitation for the sale or purchase of any securities. Any mentioned rates of return are historical or hypothetical in nature and are not a guarantee of future returns. Mark Walhout is the owner and lead financial advisor at Walhout Financial and an Investment Fund Representative at Investia Financial Services Inc.