If you’re participating in a company stock purchase plan or considering buying stock in the company where you work, you may want to think twice. Buying company stock makes you susceptible to risks you may not be aware of, such as business risk, financial risk and management risk. Along with these increased risks there are two reasons why it’s best to “Just Say No” to company stock.
Reason 1: Lack of portfolio diversification
As a young investor you have limited access to investment money and achieving portfolio diversification should be your primary goal. Portfolio diversification means investing in different stocks, in different segments of the economy, in different economies of the world. As diversification increases, the overall risk of your portfolio decreases. But when you use your limited investment dollars to purchase company stock, you’re not achieving diversification unless you’re also adding another stock or mutual fund to your portfolio at the same time. This rarely happens because company stock is typically purchased automatically every few weeks through en employer-provided plan, but you’re not enrolled in a similar plan to buy other stocks for your portfolio.
As a general rule, investors should not have more than 10% of their portfolio invested in any single stock. But when an employee purchases company stock, it usually amounts to values that are far in excess of the 10% benchmark. Being over-concentrated in just one stock exposes young investors to a number of risks that could have otherwise been diversified away.
Reason 2: Lack of risk diversification
Along with portfolio diversification you also want risk diversification. Risk diversification means diversifying the sources of risk that could make you susceptible to financial loss. This goes above and beyond the loss you may experience through investing. The principal of risk diversification suggests that if you’re already dependent on your employer for a paycheck, you should avoid becoming dependent on them for the performance of your investments, too. Think what happens if you’re invested in company stock and your company suddenly goes out of business? You’re not only out of a job, but your investments are wiped out as well. Think it can’t happen? Just remember Enron, WorldCom, Bear Stearns and Lehman Brothers and what happened to their employees when those companies suddenly went under.
When it does make sense to buy…
There are only two times when it makes sense to purchase company stock. The first instance is when you’re able to purchase the stock at a substantial discount from the fair value market price (20% discount or more). A 20% discount may be enough to offset the increased risks you have to assume when you purchase company stock. The second instance is when your company’s stock fulfills a certain need in your portfolio that can’t otherwise be met. For example, if you work for a natural resources company and your portfolio needs a natural resource stock to achieve diversification, it makes sense to purchase your company stock if there is no other suitable alternative.
Just remember, if you choose not to purchase company stock it doesn’t make you a bad or disloyal employee. It just means you’ve done your homework.