When investment risk comes to mind, what do you think of? Like most people, you might say “losing money.” But other investment-related risks are worth considering, too – and you might be particularly exposed to one of them: overconcentration.
Specifically, you could be at risk of holding too much money in too few investments, especially if you have a large financial stake in your place of business. This problem could arise if you have a lot of company stock in your 401(k) and a large amount of unexercised stock options.
Until the early 2000s, many people thought it was acceptable to include high percentages of their company stock in their 401(k) plans. Then came the collapse of Enron, in which thousands of employees – encouraged by their employer to fund their 401(k)s with company stock – essentially lost everything. Since then, the combination of regulatory changes and a heightened risk awareness on the part of employees has resulted in much lower percentages of 401(k) plans being devoted to company stock.
The problem hasn’t completely disappeared, as company stock still makes up a sizable part of many people’s 401(k) plans. The risk is twofold: First, too much company stock leaves you vulnerable if your company goes through some bad times, and in a fast-changing world, it’s really hard to predict any company’s future. Second, if you depend on your employer for your income and you own a large amount of its stock in your 401(k) plan, you face potential double jeopardy – in a worst-case scenario, if the company struggles so much that it’s forced to downsize, or even go bankrupt, you could lose your job and a big part of your retirement savings.
So, how much company stock should you own in your 401(k)? You might hear that it’s smart not to exceed the 10% - 15% range, but there’s no one right answer for everyone. Your own percentage will depend on many factors including: the strength and outlook of your company, the other investment options in your 401(k) plan, the asset allocation in your non-401(k) investments, and so on.
Also, when considering how much company stock should go into your 401(k), you’ll want to weigh the impact of your stock options. If you’ve been granted many of them, you’re adding to the financial risk of being tied too closely to your company’s fortunes – after all, you’re hoping to be able to exercise the options when the stock price has gone up, just as you hope the stock price is high when you eventually begin tapping into your 401(k). That’s a lot of “hope” involved for something as important as your retirement savings. So, if you do own a lot of these stock options, you may want to consider scaling back on the company stock within your 401(k).
Now, let’s move beyond the issue of company stock into one other aspect of overconcentration of assets in your portfolio. Specifically, this overconcentration can occur without your even being aware of it. Suppose, for example, that you have decided your portfolio should contain 60% stocks and 40% bonds, cash instruments and other investment types. You reached this figure by taking into account several factors, with your risk tolerance being one of the most prominent. But over time, let’s say your stocks have grown so much that they now actually take up 70% of your portfolio’s total value. And because stocks are the asset class with the greatest volatility, that 70% figure may be too high for the amount of risk you’re willing to take. When that happens, it’s time to rebalance.
Overconcentration can limit your investment success because it limits your opportunities. As a very simple example, suppose you’re heavily invested in domestic growth stocks while owning almost no international stocks. In a given year, the domestic stocks could be the best-performing asset class, but the very next year, they might fall down the list, while international stocks move to the top. If you don’t have much international exposure, you could be missing out.
Ultimately, overconcentration involves a lot of risks – and few rewards. To learn more about avoiding overconcentration and taking the steps necessary to maintain a diversified portfolio, contact an Edward Jones financial advisor.
Diversification does not ensure a profit or protect against loss in a declining market. Investors should understand the risks involved in owning investments, including interest rate risk, credit risk and market risk. The value of investments fluctuates and investors can lose some or all of their principal.