Financial Planning

Employer Stock, and the Risk in Buying What You Know

Holding a huge position in any individual stock is risky. Especially employer stock.

Unfortunately, Enron wasn't an isolated case. Photo by James Nielsen/Getty Images.

When I was a fresh-faced college graduate first entering the securities industry about a decade and a half ago,[i] advice many folks spouted amounted to this: Buy what you know.

Most attributed it to Peter Lynch, then manager of the Fidelity Magellan Fund (at the time, the world's largest mutual fund). Lynch was well-regarded-still is, by many-and was a very relatable man. Common-sense, simple statements like, "Buy what you know," rang true to many because of their simplicity. [ii] Now, if you are a professional investor, you're probably familiar with a lot of companies. After all, it's your profession. And if you are Lynch, running the world's largest fund, you have a team of analysts who know a lot of companies indeed. Diversification isn't hard to obtain given this wealth of knowledge. But if you're average Joe or Jane, and you have a full-time job, family or hobbies, it can be much harder to have many companies you know well.

In my view, this is how so many folks wind up with huge slices of employer stock in their 401(k)s and, after retirement, IRAs-familiarity. But doubling down on your employer-since your income and retirement assets hinge on a single firm-is a bad idea. While sometimes owning company stock is unavoidable due to contribution matching provisions or for other compensation-related reasons, in my view, the moment you can diversify out of employer stock, do it.

We got another reminder of why Friday afternoon, when a US District Court Judge ruled in the Lehman ERISA case. For the second time, Judge Lewis Kaplan rejected former Lehman employees' suit filed against Lehman executives, including former CEO Dick Fuld.

The employees in the suit claimed Lehman had a fiduciary duty to blow out of Lehman stock (or suspend new investments into it) when the trustees knew the firm was troubled, prior to filing for bankruptcy in September 2008. Now, I am not a lawyer, and I don't want to be one either. I won't attempt to interpret this decision whatsoever beyond pointing out a couple oddities you may find interesting. One, from my perspective, it seems an odd thing to file suit over, considering the Lehman fund was optional in the plan-not mandatory, according to the case filing. And two, assuming Fuld and friends had in-depth knowledge of Lehman's woes in time to liquidate or suspend new investments into the Lehman stock fund, suspending investments and selling on that knowledge seems strikingly similar to insider trading. If they went public with their plans to liquidate the 401(k)'s holding, the jig would be up. My guess is efficient markets wouldn't look kindly on executives announcing they'd suspend investment into company stock.

But all that is beside the point. I bring this case up because investors should look at this story and learn for the future. This case is not an isolated one. Fourteen years ago now, the danger of investing in employer stock in 401(k)s was laid bare by Enron's 2001 bankruptcy.

When Enron was proven a house of cards, those poor employees who committed a single investment error lost not only their job, but a slice of their retirement-in some cases, a huge slice. One such employee, interviewed back in 2001, saw his account drop from $470,000 to $40,000. He wasn't alone. Enron's employees lost an estimated $850 million on Enron stock held in 401(k) accounts. While some money was recovered after legal action, many took substantial, permanent losses. And even that recovery took years.

These are two of the biggest bankruptcies in recent memory, and both times employees were burnt by owning employer stock. In my experience in this industry, they aren't alone or unique at all. Many, many folks have huge positions in stocks that are "familiar." I think it's that persuasive common sense: Buy what you know.

But you should never take that common sense to the extreme. Even if you are the CEO or CFO of a public firm, there may be many pertinent factors you don't know. If that weren't the case, firms wouldn't go bankrupt to begin with, because executives would see issues coming a mile away and, presuming they aren't totally incompetent, navigate the firm around them. No one has that kind of complete visibility. It is unreasonable to expect it of them. Or yourself.

When you're working, your salary is contingent upon your employer's solvency. Investing hugely in employer stock when you could do otherwise is doubling down on that risk. We aren't in a bear market today and one doesn't seem likely to come soon, but when it does, I am betting there will be more stories like this one. Lifelong employees who lost everything. Men or women a year from retirement whose nest egg was wiped out. Angry folks picketing in front of offices over lost retirement money. You don't want to be them.

Take this suggestion now: If you have heavy doses of employer stock in your 401(k), don't worry about how high it may soar. Don't convince yourself that because you know a company you know everything about that stock. Worry about what happens if you don't.

[i] I am not fresh faced anymore, which is a-ok with me.

[ii] If you say, "Who would buy what they don't know?" consider: Many people did. It was called the tech bubble, when many investors bought anything with "dot com" in the name.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.