Thoughts on (not) owning company stock

At work recently some discussion came up about owning stock in the company we work for. I briefly mentioned the fact that I do not own a single (vested) share of stock in the company and was treated with scorn and disbelief. Am I some sort of traitor? Do I not believe in the company? I tried to explain that no, it had nothing to do with any of that, but didn't get a chance to fully explain my reasoning. So here goes.

While the decision is certainly made easier by the fact that the stock in question has grossly underperformed the market for more than five years, I base my reasoning mainly on sound investment policy. Even if I worked at Google or Apple I would do the same (in theory, anyway).

It's all based on one basic principle: not being a sucker. There are three reasons why you risk being a sucker if you have large holdings in the company you work for, all related to diversification:

• If you are an employee of a company, your salary is tied to the fortunes of that company. If you have lots of stock in the company, then so is a large part of your savings. This is a very strong correlation, and correlation among financial assets is very bad. If anything bad happens to the company, you could lose not only your job, but also your savings. There are many examples of this happening - we've all heard the stories of the thousands of Enron employees who lost their jobs along with their entire 401(k)'s (100% Enron stock). A similar thing happened recently to all the United Airlines "employee-owners" who foolishly voted to convert their pension fund into United stock: the company went bankrupt, the stock became worthless, and many of them were laid off.
• It is a bad idea to own large amounts of any one individual stock, regardless. Each additional share has a 100% correlation with all the others and creates un-hedgable risk that the entire position might blow up. Examples of people losing large amounts of money on single stocks are so common that they're not even worth repeating here.
• Along the same lines, you don't want to have significant holdings in any one individual market sector either, because all of those stocks correlate fairly well with each other, and that correlation creates risk. There were many people who worked in the tech industry during the late 90's and "diversified" their portfolios by owning a variety of telecom and dot-com stocks (since those were the "hot" sectors). When the bubble popped, they had significant losses (and were probably laid off as well). So you don't want to own lots of stock in the sector you work in, which by definition includes your company.

At this point the common responses are along the lines of "Bah, I don't expect that our company (or market sector) is about to go bankrupt!".  As Nassim Nicholas Taleb might point out: that's exactly the point. Nobody expected Enron to suddenly blow up: the sheer unexpectedness of it is precisely what made it such a spectacular disaster. If the market expects a company to go bankrupt, the stock will already be trading around $0, so it will be too late (see: Freddie Mac, GM, etc.). The unexpected events (so-called "black swans") can be the most risky and need to hedged against along with the run-of-the-mill risks.

With all that in mind, there are some questions which inevitably pop up:

• Don't you lose out big-time by immediately exercising stock options? Shouldn't you hold them for a while until the stock has gone up considerably? Sure, but those are stock options and are a different beast with their own set of incentives. But given the recent industry trend toward eliminating stock options and replacing them with stock "awards" and "grants", there are fewer and fewer incentives that favor the employee holding onto the stock. Companies started switching away from options after the Enron scandal in order to avoid large "surprise" expenses on their accounting books, which means that typical employees will no longer be "surprised" to strike it rich one day. With stock grants, there's basically no particular incentive for employees to hold onto the shares (and many disincentives, as discussed above).
• What about the tax implications? Won't there be unfavorable capital gains taxes if you sell immediately? At first I thought this would be a problem as well, but after looking into it, it turns out that it isn't. In fact, it can actually simplify your capital gains taxes if you sell all of your shares as soon as they vest. Stock grants are treated as ordinary income on vest, and some of the shares are withheld for taxes at that point. So the remaining shares have already been taxed, and if you sell at that point then there's neither a capital gain nor a capital loss, and thus no further tax implications. With no capital gain, there's also no particular incentive to hold the shares for at least a year in order to get the long-term capital gain tax rate.
• What about employee stock purchase plans? These work slightly differently, but end up being similar. Typical plans allow employees to purchase the company's stock at a given discount, like 10%. As long as the purchase date is the same as the vest date (with no backdating), then there's no capital gain (companies are also switching to this model in order to make their accounting simpler). The 10% discount is treated as ordinary income paid to the employee and is taxed at that rate. So again, with employee stock purchase plans, there's no particular incentive to hold onto the shares for any amount of time. If you sell them immediately after purchasing them, you can make an easy risk-free 7.5% return on your money (assuming a 10% discount and a 25% marginal tax rate).

So after all that, what should you invest all the remaining money in? That's a large topic which I will save for another post sometime in the future, but the answer is simple: just listen to Warren Buffet (the world's richest person) and buy an S&P 500 index fund. I deviate slightly from his advice since I feel that the S&P 500 weights your portfolio too heavily towards big U.S. multinationals and exposes you too much to downturns in the U.S. economy, so my investment strategy is basically to go with no-load S&P index funds plus some as-cheap-as-possible international index funds. I'll talk more about the reasoning and mathematics behind it in a future post.

Financial Profiling & Optimization

Sometimes I wonder if I am spending too much money and should be saving more. It's tempting to try to micro-manage things by clipping coupons or skipping out on meals out with friends, but this strikes me as being similar to premature optimization of code, which as Knuth would say is the "root of all evil."

Just as it's not worth optimizing the 90% of the code where your program spends less than 1% of its time, it might not be worth packing your lunch every day to save a dollar a day ($250 per year) if your real problem is that you unnecessarily spend thousands of dollars on new laptops or other expensive equipment each year.

So what's the first step before I can figure out what to optimize? Profiling, naturally. About a year ago I grabbed a copy of MS Money, which is a personal finance tracking program. It can go online and download your bank account information and credit card statements. It tracks each transaction you make and uses heuristics to assign them to various expense categories. For example if Safeway is the merchant, it'll assign it to Groceries, if it's Comcast, then Utilities, and so on. Sometimes it doesn't know what a specific merchant should be assigned to so you have to configure it.

Once that's all set up, it can generate all kinds of plots showing your cash flow over time, estimated monthly budgets based on trended spending, and various other reports. Here's a pie chart of my spending over the last year:

Without this tool I would probably have had a hard time even estimating the percentage of my spending which goes into various categories, so it was quite interesting to see it charted like this.

The biggest item that jumps out of the chart is obviously "Mortgage/Rent", which in my case is just Rent. It accounts for nearly half of my spending, if you include Utilities (electricity, water, internet) along with it. I'm not sure whether this is a good or bad observation: on one hand I am spending a ridiculous amount of money on rent each month, but on the other hand it's nice to know that I'm not spending a similarly ridiculous amount of money on anything else.

"Education" is the next biggest category, which includes grad school tuition, fees, textbooks, etc.. I'm OK with spending a good chunk of money on this category since self-improvement and continual learning is a good thing. It's also nice that these expenses are completely reimbursed by Microsoft, so the chart of my "real" expenses should probably not even include this category (in which case Mortgage/Rent would fill more than half the pie).

Next biggest is "Hobbies/Leisure", which contains a large range of transactions, the largest of which are from "AMAZON.COM", "GAMESTOP/EBGAMES", "APPLE ONLINE" and "REI STORES."  Overall I'm not too concerned about the current size of this pie slice since Hobbies/Leisure is basically the category for "what you do with your spare time," which, in the end, is the whole point of working and making money. I was a bit surprised at the total cost of my Amazon purchases over the last year - I could probably be a lot better about borrowing "read once" books from the library rather than buying them outright (Amazon Prime makes it too easy..).

"Automotive" is up next, which seems to be about equally split between car insurance and gas. I think I already have my car insurance pretty well optimized, so about the only way to reduce spending here is to drive less.

I'm lumping Utilities in with Mortgage/Rent, so "Groceries" is next. The final number in this category was another minor surprise and is probably a good area for optimization. Whole Foods organic milk and cereal apparently add up pretty quickly.

The rest of the spending categories don't sum up to much, so some of them are actually surprising for being so small. I'm disappointed that "Travel/Vacation" is almost not even visible on the chart. I hope that next year's chart will show Travel/Vacation making some big gains. "Gifts" is one category which is too small to show up, which would be totally pathetic of me if it weren't for the fact that most of my gift purchases were probably from Amazon and thus got stuffed into the Hobbies/Leisure slice.

One thing which is notably missing from this chart is money allocated to savings accounts & stock investments (I guess they aren't "Spending" since I still have the money). I had to generate a separate report for savings & stock investments and was pleased to find that the total number there was about equal to the total number in the Spending chart, which means that I have a savings rate of 50%, which is a lot better than the U.S. average, which is hovering around 0% even with the recent "stimulus" package.

Overall this was an interesting exercise to do. Now that I know the actual numbers I don't feel all that guilty about spending too much (except for in a couple of areas). In fact, I'm now feeling like I can probably afford to spend more, especially in "Travel/Vacation".