Preventing Irrational Decisions About Selling Company Stock Or Exercising Options
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. Behavioral economics and investor psychology offer insights that can help you develop a personally acceptable approach.
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 runs against the principles of 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. However, extreme risk aversion can interfere with 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.
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.
The Endowment Effect, a term attributed to the Nobel-winning economist Richard Thaler, suggests that people often demand much more to give up an object that they already own (e.g. company stock) than they would be willing to pay to acquire it. This can lead to the mistaken belief that the price you would sell your company stock at is greater than the price it's trading for, encouraging you to think your stock is undervalued. One way to test whether you're falling victim to the Endowment Effect about your company's stock is to ask whether you would buy it at its current price if you did not already own it or have a requirement to hold it.
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 views his winnings as just extra money for yet unknown purposes, leading you to have no plan for your company stock and options.
You want to have realistic expectations about the wealth that could be generated from equity compensation. However, don't wait too long before you 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 have a better chance of recognizing unhelpful emotions and balancing 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.