The pitfalls of overconcentration in company stock

When making life decisions, experts often advise to keep your emotions in check. That’s especially true when it comes to decisions we make in our financial lives with investing. So many of us, however, have complex relationships with our finances which can often cause us to invest emotionally rather than rationally.

Even the financially successful and savvy are prone to emotional decision making. Over the years, I’ve worked with senior corporate executives who, despite what they may know about the importance of diversification, have high concentration of their employer’s stock. It may be from stock bonuses or options, or even their own market purchases that have caused them to “stock” pile.

It could also be that they’re impacted by a human behavior and nonrational cognitive bias: one in particular is the Endowment Effect. Coined by Richard Thaler in 1980, it’s built upon the simple premise that people believe an object they own is worth far more than they would be willing to pay to have it in the first place. As such, executives who are entwined with their companies may believe the value they perceive for a stock they already own is greater than the price the marketplace offers.

This brings up an important consideration for investors: Am I impacted by the Endowment Effect? I often tell my clients to ask themselves a simple question: If I didn’t own the stock or have a contractual agreement to hold it, would I purchase the stock at the current price based on its attributes? If they wouldn’t purchase it, chances are they’re being influenced by the Endowment Effect.

When making investment decisions, particularly those around asset allocations, investors must have a certain level of comfort with the choices they make. A senior executive who’s knowledgeable about his company and industry may certainly feel a level of comfort and safety in dealing with the familiar. But that may not be the only reason for their decision to purchase additional stock. Other cognitive biases may be at work, including:

Anchoring. Very often investors may be attached to a specific price, despite what data and market changes may indicate. As a result, they may not consider factors that could impact the marketplace’s perception of the company. In the case of the corporate executive, they may even believe that the value of the stock exceeds the need to diversify their portfolios, one of the most basic tenets of successful investing.

Overconfidence. With so much access to relevant data, news, and competitive assessments, senior executives often believe they have superior insights into the value of a stock. While it’s certainly important for an executive to have confidence in the company that employs them (particularly if they’re helping lead the company), overconfidence can impact their ability to objectively assess the merits of the stock.

Loss aversion. Investors react differently to losses and gains; they’re far more likely to feel the pain of a loss than the joy of a gain of the same magnitude. For this reason, executives may avoid selling stock during down markets to circumvent the pain of a loss. Sometimes they may even purchase additional shares at lower prices to reduce their break-even price. In doing so, they can make small losses even larger.

There’s no question that company stock ownership can be a lucrative benefit and a strong sign of professional success. However, overconcentration in that stock can be perilous, particularly when investors overlook the importance of diversification. That’s why it’s critical to be objective about the stock you own — and to make measured, rational decisions that are in your long-term best interest.