Better Manage Your Stock Options… by Avoiding These 5 Mistakes

This post was originally published on Beyond Your Hammock

Stock options are a type of equity compensation, which is a way for employers to reward key employees beyond the usual paycheck. Most equity comp packages can provide a great opportunity to build wealth, but managing that well requires advanced planning.

If you want to avoid making big mistakes with stock options, there are specific investment risks to acknowledge and address. While both incentive and non-qualified stock options, along with RSUs and ESPPs can provide serious financial upside, you have to understand what you have and how to use it to your advantage.

Otherwise, you risk mishandling a powerful financial tool and ending up in a tough position with your assets.

Here are 5 big mistakes with stock options you’ll want to avoid, and the top things to know to create a better financial strategy with your equity compensation.

Mistake 1: Failing to Read the Plan Document

Your plan document for whatever equity compensation you have acts as a sort of owner’s manual. It’s important to have it and review it, because it contains all the facts you need to know about the equity you have and how it works.

Too often, we see people who have stock options or another form of equity comp — but they have no clue what they have, if there are any limitations, and what specific rules their company might use when it comes to granting this kind of compensation.

This is a huge mistake with stock options, but it’s an easy one to avoid. Just read your plan documents!

Because yes, the littlest details matter here. Here’s a common way people get tripped up and make mistakes with stock options: they think incentive stock options and non-qualified stock options are basically the same.

That couldn’t be farther from the truth. While they both have “stock options” in the name, these forms of equity act very differently and may receive different tax treatment… which can have a massive impact on your cash flow and overall financial plan.

You can say the same for RSUs, or restricted stock units: if you receive grants of RSUs, you need to know they behave very differently than either type of stock option. They’re taxed differently, too.

And then you have ESPPs, or employee stock purchase plans, which are again different than the other types of equity mentioned above.

This is why your plan document is so important. It should tell you exactly what kind of equity compensation you have and all the rules for what you can do with it, when, and if there are any restrictions or exceptions.

Read it carefully and make sure you fully understand all the details. If you don’t understand something, a potential first step is to reach out to your HR department to ask for help or more clarification.

But a better, more strategic move might be to work with a financial planner with experience in setting strategies for equity compensation. Getting a tax advisor with similar experience is just as important.

These professionals can provide expert recommendations about what to do with your options, RSUs, or ESPP shares in the context of your entire financial plan. That means looking at how your equity comp might interact with your existing goals, overall tax situation, and current investment strategy.

Only by taking this comprehensive view can you determien the absolute best moves to make with the equity you have (while avoiding big mistakes with stock options).

Mistake 2: Ignoring the Concentration Risk You May Face

FINRA describes concentration risk as “the risk of amplified losses that may occur from having a large portion of your holdings in a particular investment.”

Most of the time, we avoid concentration risk in investment portfolios through proper diversification across global markets. But this particular investment risk can be harder to manage if you have equity compensation, because you usually start automatically building a concentrated position in a single stock through contributions to ESPPs or grants of RSUs or stock options.

It might not be your intention to hang on to too much of one stock, but because vesting schedules and contributions are usually set in advance, it’s easy to end up having a big percentage of your overall investment portfolio be represented by your company’s stock.

Concentration risk is something you likely want to avoid no matter what kind of stock it is — but when it comes to your employer’s stock, this can become even more hazardous than normal.

Not only is a large percentage of your portfolio tied up in a single stock, but that same company is also the one that signs your paychecks.

When both your income and your investments rely on the good performance of your employer, you expose yourself to potentially catastrophic downsides.

Generally, we suggest that clients avoid maintaining more than 5% of their net worth in any one stock. When it comes to your own company that you also rely on for regular income via a steady paycheck, you might want to hold even less in that stock to better diversify your financial life.

(But again, that’s where the customized advice from the pros should come into play. 5% is a great guideline for some people; others need to maintain even smaller positions. And then there are some folks who can and even should consider more concentration. It depends on your unique situation, which an advisor can help manage with you.)

This is one of the most common mistakes with stock options that we see people make… because it’s really tempting to want to exercise and hold shares in hopes that your company will be the next one to go big.

And this can happen; the upside can be significant and you don’t want to be the one person in your office who missed out. But there’s no upside without downside.

If experiencing the full extent of that downside risk — like a steep decline in the value of the company stock plus potential loss of income if you were to lose your job — would break your financial plan, then you literally can’t afford to gamble on holding too much of a single, concentrated stock position.

Remember that managing concentration risk has little to do with any particular company or employer (or how you feel about the company); selling shares of company stock does not mean you don’t believe in the business or think it will do poorly.

It is simply a risk management strategy, and we know that more diversified portfolios leave you with less exposure to investment risks in general. They also reduce volatility in your portfolio, and we know that portfolios with lower volatility tend to perform better over the long-term.

That’s not to say investing in your company is always a bad idea; just that you cannot ignore the risk you take when you do so. The mistake is not evaluating concentration risk at all, and failing to account for the potential impact of being exposed to it.

Your financial plan should account for how much risk you can take on here, or if it makes more since to simply exercise and sell options, units, and shares when you can to lock in gains.

Mistake 3: Missing Out on the Expiration Date

Mistakes with stock options don’t necessarily happen because the options themselves are too complicated for you to manage, and you didn’t understand what to do with them.

Although they can get tricky to set strategies around, you can make big mistakes simply by not paying attention.

As in, not paying attention to expiration dates or trading windows, and then missing them. This is where your plan document can come in handy again: it should tell you all the details on the deadlines you need to know.

You’ll need to review your plan doc or talk to HR to know your specific timelines and dates to note, but in general, understand that stock options are a “use it or lose it” sort of benefit.

Let’s say you hold company stock and your options are in the money — meaning, they’re worth more on the open market than the price you pay when you exercise options and buy shares.

You could exercise your options and purchase the underlying stock for less than what it’s trading at on the exchange… which means you could turn around and sell the shares for more than you just paid for them, therefore generating a profit.

But your options don’t have endless shelf lives. Whatever options you old have expiration dates, and if that date comes before you choose to exercise your options… that’s too bad.

The options expire, you lose your chance to exercise them, and ultimately you miss out on an opportunity to increase your net worth.

Don’t let this happen to you! Know these deadlines and have a plan for what action you’ll take before they hit.

Mistake 4: Letting the Tax Tail Wag Your Stock Option Dog

When you exercise your stock options, what you’re doing is exercising your right to buy company stock at a certain price. (Sometimes that comes with an added bonus of doing so at a discount.)

When you exercise your stock options, you have a choice about what to do with them:

• Sell the shares immediately
• Hold the shares for a period of time

If you sell your shares immediately, you get to lock in the difference between what you paid and what you can sell them for as an immediate gain, or profit.

This sounds great, and usually is for people who want to take money out of a concentrated position (a single stock) and reinvest the gains into a more diversified set of assets (like an investment portfolio that’s properly allocated and diversified across many different positions).

But there are a few things that people can see as downsides to an exercise-and-sell strategy. For one, the stock price could go up even higher in the future, so you miss out on making even more money if you don’t wait and hold your shares post-exercise.

This reason alone, however, may not be good enough to use to hang on to shares you bought through an options exercise. (Why? See Mistakes with Stock Options, #2, on Concentration Risk!).

When you exercise and sell at a profit, you will also trigger a tax bill on that gain. This is what many people claim as the reason to buy and hold.

If you hold your shares for a certain period of time (1–2 years or more), then you’ll still be taxed if you do eventually sell and lock in a gain — but at that point, you’ll be taxed at lower long-term capital gains rates.

But at the end of the day, you’re still paying taxes on gains you might receive — and if you hold shares for a period of years, you’re increasing the market risk and volatility you expose a portion of your portfolio to while waiting for a small tax advantage.

The mistake here is just assuming having your gains taxed at a lower rate is immediately and always the best move to make — because that’s simply not the case.

You need to look at your specific financial situation, your goals, your overall investment strategy, and your own comfort level with risk to determine the true best moves to make with your options before you decide to exercise and sell or exercise and hold.

Mistake 5: Not Setting a Strategy for Your Stock Options

That also gets at the number-one mistake people make with their stock options: not having a plan at all.

Without a plan or cohesive strategy, it’s hard to know you’re doing the absolute best thing for you. Lack of a strategy also leaves you more prone to making last-minute, emotional, or irrational decisions that you can’t undo.

Simply planning ahead of time allows you to get clarity on what you will do and when you’ll do it, so you can act when the time comes instead of making emotional decisions on the fly.

This makes it easier to act with confidence — and to make decisions that help add zeros on to your net worth over time.

Avoiding Mistakes with Stock Options Gets Easier When You Can Set an Objective Course

Equity comp can allow you to participate in the growth and upside potential of the company you work for, and is often a great tool to leverage to accelerate your progress toward building wealth.

But you need a plan. That means getting proactive… and managing emotions along the way, too.

Very few people with equity compensation predict that their company stock is going to drop in the near future. It is much more common to believe that the work you are doing will reap rewards and your equity will only continue to increase in value.

Again, that very well may be true. In any marketplace, there are winners and losers. It is very natural to believe your company is one of the winners.

But not every company can be, and that’s one of the downside risks we want to protect against.

The decision to diversify away from the concentrated positions that equity compensation can create is not only about whether one stock will go up or down. We want to make choices that optimize probabilities of success for achieving long-term financial goals.

If you’re still not sure where to go with your equity comp but want to avoid making mistakes with stock options, consider asking yourself the following questions:

If the value of your company stock fell (and you potentially lost your job along the way to boot), would that be a severe blow to your ability to reach your goals and afford your lifestyle now and in the future?

There is a difference between risk tolerance, or how you feel about risk, and risk capacity, or your actual ability to take risks without putting yourself in a position from which you cannot recover.

When you find yourself in a situation where the downside risk could devastate your ability to be financially successful, it doesn’t matter how you feel about the investment: you can’t afford to take the risk if you cannot recover from the potential loss.

If someone gave the value of your current company stock to you in cash, would you choose to invest that cash into your company stock?

Let’s say you own $50,000 worth of your current company’s shares. If someone wrote you a check for $50,000 tomorrow, would you turn around and buy that much worth of your company’s stock?

If the answer is no, that’s a good indication that you should not maintain a concentrated position.

What am I missing? Are there things I don’t know I don’t know about my equity compensation and its potential implications in the context of my finanical life?

Ultimately, getting the help of professionals is a good strategy to consider if you want to make the most of the equity compensation you receive, minimize mistakes that you might make on your own, and ensure that you’re not missing a beat when it comes to incorporating something like stock options into your overall finanical plan.

You may want to consider how adding on the services of a personal financial planner as well as a CPA, all experienced in helping clients with equity compensation, can improve your odds of long-term success. When the value added is high (either through maximized opportunities or reduced threats and mistakes), the cost of surrounding yourself with this team of expert is less expense and more investment in your financial life.

If you’re ready to optimize your financial life and enjoy the confidence that comes with knowing you’re making all the right moves to grow wealth and increase your assets, start here.