It’s important to understand the risks of over-investing in your company and to diversify your portfolio. By doing so, you can protect yourself against losses and build a more secure financial future.
Amos Tversky and Daniel Kahneman are two names you might have never heard of before, but in the world of finance nerds, they are as famous as Beyonce or David Beckham. These two men are the fathers of Behavioural Economics, a field of study at the intersection of psychology and economics that seeks to understand why people make certain financial decisions.
Something that frequently comes up in this field of study is the observation of people making decisions that are irrational and go against their best interests. Cognitive biases (systematic errors in thinking) are often to blame here, and one bias closely linked to the title of this article is excessive extrapolation.
A 2001 study by Shlomo Benartzi suggests that individuals who invest in the company they work for are often affected by excessive extrapolation. (i.e. Those individuals have a strong tendency to hold a large portion of their wealth in the company that they work for.) Additionally, when that company performs well, they are four times more likely to invest more heavily in it.
What is the risk of over-investing in the company you work for?
One danger is that you are putting both your income and wealth at risk. If the company you work for were to fail, you would lose not only your job but also a significant portion of your investment wealth. We’ve all seen companies fall over despite displaying no hints of collapsing (Enron, Blockbuster and Lehman Brothers). When these companies failed, their employees lost not only their livelihoods but their retirement funds as well. The previously mentioned research by Benartzi (2001) shows only 16.3% of the employees realised that investing solely in their company was riskier than investing in the overall market.
The great thing about this problem is that it can be solved through diversification. Nobel prize winner Harry Markowitz famously said diversification is the only free lunch in investing. (Meaning it is the only way to increase your returns without taking on more risk.)
Moving from a large investment in the company you work for to a diversified portfolio is likely to require some advice, though. For example, you need to consider capital gains tax and what you should diversify your investments into. This is also likely to be a good time to reconsider who holds these assets. They may be better held in superannuation, your spouse’s name or a family trust.
This is why it is important to work with your financial adviser and accountant to develop a strategy to restructure your investments.