When making decisions about your equity compensation, remember that the brain can work against you. Here are a few potential pitfalls to avoid. If in doubt, consider reaching out to a financial professional.
Lay out your equity compensation investment plan before you’re under stress or pressure to make a decision
Stock options, restricted stock units, and other forms of equity compensation are valuable benefits that require you to make investment decisions even if you don’t have much investing experience. Fortunately, investor psychology offers insights that can help you make smarter decisions with your stock compensation. When in doubt, consider seeking advice from a financial professional with the right expertise.
Experts who study investor psychology identify mind-sets that can get in the way of smart investment decisions. One of the most common is the natural tendency to focus on short-term needs at the expense of long-term interests. We all do this. It’s why many people put off saving for their children’s college tuition or their own retirement—two solid goals for stock compensation—and end up with a funding shortfall.
We also tend to feel more pain from financial losses than we feel elation from financial gains. If your company’s stock price starts to drop, it’s only natural to have a knee-jerk reaction to sell shares acquired from stock grants. However, consider whether this might cause you to miss out on long-term gains if or when the stock price recovers. (Learn tips for riding out volatility in your company’s stock.)
An interesting but perhaps less obvious phenomenon is the so-called “endowment effect,” a term coined by Nobel Prize–winning economist Richard Thaler. He found that people often demand more to give up something they own (such as company shares) than they’d be willing to pay to acquire it. This mind-set can lead you to think the right price to sell your company’s stock is much higher than the stock’s current price. In other words, it’s easy to believe that your company’s stock is undervalued, whether or not that’s accurate.
People sometimes focus too much on a single piece of information, such as a company’s highest historical stock price. Believing the stock price will return to that level, employees may cling to their company’s stock even if better investment opportunities exist. For example, with stock options, you might reason that because your company’s stock traded at $44 per share back in 2016 but fell to $35 in 2019, you shouldn’t exercise your options until the stock price has regained its former level. However, it may never return to that price during your options term, which is limited.
Similarly, we often assume past patterns influence future chances, a phenomenon known in psychology circles as the “gambler’s fallacy.” Investors sometimes believe that because a stock has declined significantly it’s bound to go back up at some point simply because it’s due for a recovery. If you did well with stock options during a previous market boom, you may be tempted to refrain from exercising your current options and selling the shares until you can once again realize a big score. That kind of all-or-nothing approach can put you at risk of losing the options altogether if their term expires, or it may cause you to hold shares for too long.
Consider developing a written strategy for your stock awards. Imagine various scenarios and how you’d respond to them. Creating investment strategies when you have ample time to consider them is better than leaving decisions until you’re under stress or time pressure.
Start with realistic expectations about your equity compensation and how it could help you reach your investment goals. A written plan can help you to resist the urge to make rash decisions during periods of market volatility, or help you feel more confident about selling your company’s stock to diversify your portfolio.
With a plan in place, you may be more comfortable making decisions and better able to balance your emotions against the discipline of price and date targets.
Talk to your TD Ameritrade Financial Consultant about the role equity compensation plays in your overall financial picture. We can get you connected to the right professionals to help you maximize your investment and wealth strategies so they can best align with your goals.
This article was developed with input from myStockOptions.com.
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