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When is the right time to exercise stock options or sell stock in your company?

Alan MacDonald

One of the most frequent questions I get from clients who own their own companies, or who have a significant portion of their money tied up in a single stock, is when is the right time to sell some (or most) of those stocks to diversify their holdings. The answer can vary from one investor to another. But there’s one common thread I’ve found that applies to almost every individual and set of circumstances.

A common thread

Let’s take three very different real-world examples. First, I have a client who, based on my advice, sold most of the stock he had invested in his own company and put the proceeds into a diversified portfolio. Unfortunately for both of us, his company’s stock has continued to do very well. Now whenever we meet, he makes a (very friendly) point of reminding me that if he hadn’t followed my advice, he would’ve been worth twice as much as he is today.

On another occasion, I met with a senior high-tech executive who had about $6 million of his company’s stock. I told him that if he wanted to secure his retirement, he should sell at least half of his holdings and put the proceeds into something more broadly diversified. He was 66 at the time, and his response was: “with all due respect, if I had listened to someone like you 30 years ago, I’d have $540,000 today instead of $6 million.” He shared his financial records with me, and sure enough, he was exactly right.

Finally, several years ago, I had the pleasure of meeting with a CEO whose net worth was in the high eight-figures. Almost all of his money was invested in the company he ran, and most of his wealth was created when that stock went to the moon. When I told him he might want to think about diversifying, he said he was worried it could set a bad example for everyone else at the company if he, as the CEO, suddenly seemed to lose confidence in his own company. Besides, that stock had been very good to him so far, and since he didn’t see any storm clouds on the horizon, why fix something that wasn’t broken?

From concentration to diversification

These three stories all have one thing in common: investors who become very wealthy by having most of what they had in a single stock or company, and then watching that investment catch fire.

But even after hearing a handful of stories like these over the years, the number one piece of advice I still give any of my clients who are heavily invested in a single company, is to take their investments from concentration to diversification as soon as they possibly can. Why?

Because numbers don’t lie. There will always be a few outliers who get lucky and reap huge rewards, at least in the short-term. But for the vast majority of us, the simple reality is that diversification is a much smarter investment strategy almost every time. 

Numbers never lie

Just consider how those three examples I told you about ended up working out. The first one, my client, is still happily reminding me just how much my advice cost him (though neither of us has a crystal ball, so his decision to sell could still very well end up being the right choice by the time he retires). But the investors in the other two stories weren’t nearly so lucky.

The second investor was a senior executive at a well known tech company that didn’t make it. When the stock initially dropped by 50 per cent, he doubled down, borrowing money to buy even more shares at what he saw as bargain-basement prices. Within a few months, his life savings were wiped out, his holdings were worthless, and his $6 million fortune was gone.

As for the CEO in the third example, he ended his career driving a truck for a living. In the face of new competition, his company unexpectedly went to zero in a matter of months, and took all but a small portion of his net worth along with it.

He sacrificed his health and his family trying to keep the wheels on, and when he lost his job along with the rest of his company, he didn’t have anything left to give to the enormous demands of holding a senior technology position. The only silver lining is that, thankfully, he put just enough money away to fund a modest retirement after the great majority of his wealth evaporated.

Of course, these are all just anecdotes. But after 30+ years in this business, my experience is that diversification turns out to be the right choice most of the time. Why? Because in cases where a stock increases so much that it becomes most of your net worth, it’s probably become trendy. Trendy often means high and often unsustainable valuations.

Now, when I talk about diversifying, I don’t mean avoiding stock purchase plans. Stock purchase plans offer some serious discounts on equities to employees who are lucky enough to get them, and they can be a great way to accumulate wealth. But whenever a particular stock rises so quickly in value that it becomes an oversized part of your portfolio, it’s time to consider moving some of that hot stock into other investments before the markets become fickle and move on.

The cost of taking money off the table can be daunting. There are capital gains to consider. The potential loss of future opportunities that my client in the first example likes to remind me about. And if you own the company, there are very real worries about what selling off a big piece of your holdings might signal to your employees, investors, or the markets themselves.

Every individual circumstance is different and you need to be sure to consult with your own professional advisors. But as these three examples show us, in the majority of cases, diversification is still the smart thing to do. A diversified portfolio is no longer a bet. A single stock is a bet; and it’s up the owner to decide how much they are willing to gamble.

This article is supplied by Alan MacDonald, an investment advisor with RBC Dominion Securities Inc. Member–Canadian Investor Protection Fund.