Basics: Benefits

You may have restricted stock that is about to vest, in-the-money stock options, an upcoming ESPP purchase, and/or outright holdings of company stock. Whether you consider yourself a novice or a sophisticated investor, it can be hard to decide what to do. The study of behavioral economics and investor psychology offers insights that can help you develop a personally acceptable strategy.

Common Hangups

Many reasons contribute to mistakes or irrational decisions about investments. Overconfident or overly emotional responses to investment situations are common. They pose risks when they enter decision-making about your company stock.

Overconfidence Takes Many Forms

You may be overconfident about your investing experience, your knowledge of stock options and/or restricted stock, or the future prospects of your company. Alternatively, if you have a prominent position at your company and excel at making business decisions, you may think it will be easy to choose the best strategy for your stock grants.

When you add to this a strong belief that good corporate citizens should hold on to their company's options and stock as long as possible, you may be setting yourself up for disappointment. Your understanding of your company, its financial prospects, and leadership team may lead you to believe you know what to do, but forces beyond your control can cause your company's stock price to plummet. Overconfidence about your company can make you wait too late in your option term to exercise. Keeping a big chunk of your net worth dangerously concentrated in your company's stock interferes with healthy investment diversification.

In fact, executives who are sophisticated investors sometimes make the worst mistakes, including margin loans that turn sour, hedging strategies that backfire, or incentive stock option exercises that trigger the painful impacts of the alternative minimum tax. Hubris can be as risky as ignorance when it comes to smart financial and tax decisions related to your equity compensation.

Alternatively, you may be overconfident in your financial advisor or CPA. However, your advisor that helped you make smart decisions about your investments may not be experienced with equity compensation and its tax nuances. While you may like to delegate your investments to someone else, when it comes to decisions about company stock and options, you need to have enough knowledge to understand the various strategies and tax pitfalls for yourself.

Emotional Responses: Risk Tolerance And Loss Aversion

Financial crises and occasional big market swings can help you identify your tolerance for risk, but it is easy for excessive risk-aversion to interfere with your financial goals. Aversion to future risk may be compounded by any past experience you have had with once valuable stock options that become worthless underwater options.

Behavioral psychologists find that some people develop a strong tendency to place too much emphasis on loss aversion, focusing more on preventing losses than on seeking gains. This can lead you to sell restricted stock or exercise options immediately after the grant vests. While you may feel this helps you preserve any small gain you have, it takes away the wealth-building potential of equity compensation.

Unrealistic Targets

Conversely, there is a danger of waiting too long to exercise/sell because you have fixated on a stock price that is no longer a realistic selling point. For example, you might reason that because your company's stock traded at $44 per share back in 2007 but fell to $20 in 2009, you should not sell until the stock price has regained its former level. However, it may never return to that price during your option term. Similarly, if you made a killing on your employee stock options during the last big tech boom, you may be tempted to refrain from exercising and selling until you can again realize a big score. An all-or-nothing approach, waiting for the unrealistic target price or the big score, risks losing the options altogether when the term expires, or might cause you to hold the stock too long.

Overcoming These Hangups

Your goal is an approach that controls anxiety, overconfidence, and greed so that they do not end up controlling you. Similarly, don't think like a gambler or a speculator who mentally characterizes his winnings as just extra money for yet unknown purposes, leading you to have no plan for your company stock and options.

Realistic Goals

You want to have realistic expectations about the wealth that could be generate from your equity compensation. However, don't wait too long before your decide what to do about your options and company stock. Put your equity compensation in one or more special "mental buckets" that stand for the money needed to fund a long-term life or investment goal. One of the simplest (but not simple) approaches is to then link these goals for your equity compensation to price targets, which you can adjust to include date targets for exercising options later in the term (e.g. X% monthly during last two years of the term).

Your goal could be to use the after-tax proceeds from the sale of company stock, an option exercise, or restricted share vesting for a kitchen renovation, big trip, college tuition, or a hefty investment in a mutual fund or ETF. It may be that the exercise of the options when it reaches that target price is not the most economically efficient decision, especially when compared against a fancy (and often inaccurate) mathematical option valuation model. However, with volatility in the market, it can be psychologically more appealing to assign the company stock to a specific use that matters to you instead of worrying about leaving money on the table.

The Value Of Planning

With a plan in place, you are less likely to be anxious about volatility. You recognize your emotions and balance them with the discipline of price and date targets. Your attitude about equity compensation will change when you feel it has provided value that has improved or changed your life.

Bruce Brumberg is the Editor-in-Chief and co-founder of myStockOptions.com.