Equity Compensation: Big Opportunities, But Beware the Risks

We all like hearing that we’re good at our jobs, especially when those kudos come bundled with dollar signs. Sometimes, a company might even offer you a piece of the pie in the form of equity compensation. While a small slice can boost your income, a larger slice might offer a life-changing financial windfall—or not. Luck plays a role, but managing your equity compensation wisely is crucial. Understanding the details of your equity stake and how it fits into your overall financial plan can help you balance its potential risks and rewards.

Equity Compensation Basics

Equity compensation can come in various forms, such as stock options, restricted stock units, or participation in an employee stock purchase plan. These packages often come with a vesting schedule that determines how quickly you can take ownership of your shares, helping companies retain valuable employees longer.

Each part of your equity compensation package—from vesting rules to the types of shares you might receive—comes with a slew of caveats and fine print that are essential to understand. For example, stock options might come with an expiration date for exercising those shares. Miss that date, and you may miss out on acquiring company stock at a deep discount. Understanding the tax implications of your equity compensation can also help you manage your tax burden and keep more of the equity you’ve earned.

At WealthBuilders, we commonly advise clients on the wealth-building possibilities of their executive compensation packages. This includes helping you make the most of the opportunities, integrating the package within your greater wealth goals, and collaborating with other resources available to you. Your company’s HR department, accountant, and lawyer can also provide valuable insights.

Understanding the Risks of Equity Compensation

One downside of equity compensation is that it can tie up a large portion of your wealth in a single stock, known as concentration risk.

Not all risk is bad. In fact, investing involves taking on risk in exchange for potentially higher returns. This is systemic risk—the risk inherent in the financial markets at large. However, concentration risk doesn’t reward you in the same way. While there’s potential for your company to perform extraordinarily well, concentration risk also means your wealth is tightly tied to one company’s performance. If that performance is poor, it can spell trouble for you.

Every company faces idiosyncratic risks, such as scandals or disruptions from competitors. If the company’s stock price falls, your concentrated portfolio will follow suit. Additionally, relying on your employer for both income and long-term savings can be precarious. If the company performs poorly, you could lose your income and a significant portion of your wealth simultaneously.

For example, during the pandemic in 2020, ridesharing company stock prices tended to lose value as ridership plummeted.  Employees with equity compensation in these companies not only lost their jobs but also a chunk of their potential wealth.

Holding concentrated positions in stocks is speculative and similar to stock picking. The odds of picking a stock that outperforms the broader market are low. In 2023, 60% of actively managed large-cap U.S. equity funds failed to beat the S&P 500. Concentrated investments also come with opportunity costs, as they can prevent you from sharing in the gains of a broader stock market rally.

You might think you know your own company and are confident in its future. However, this familiarity can lead to a behavioral tendency known as familiarity bias, making you falsely assume your company is safer or a sure thing compared to others. Rely on objective data and research to inform your investment decisions.

Solving Concentration Risk

Minimize concentration risk through diversification by carefully divesting company shares and investing in broad market funds. Holding large swaths of the market helps smooth out volatility, maximize long-term returns, and manage systemic risks while reducing unnecessary idiosyncratic risk.

If you work for a privately held company, selling your shares can be trickier and sometimes not possible. In such cases, we can sit down with you to weigh your options for minimizing concentration risk. This might include building a larger emergency fund for unexpected events or exploring financial strategies to hedge your equity position.

Whatever your equity compensation package looks like, you don’t have to navigate its complexities alone. Reach out to us to learn more and discuss your options.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.  All indices are unmanaged and may not be invested into directly.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

Stock investing includes risks, including fluctuating prices and loss of principal.​