Question: You are discussing your 401(k) with Dan Ervin, when he mentions that Sarah Brown, a representative from Bledsoe Financial Services, is visiting East Coast Yachts today. You decide that you should meet with Sarah, so Dan sets up an appointment for you later in the day. When you sit down with Sarah, she discusses the various investment options available in the company’s 401(k) account. You mention to Sarah that you researched East Coast Yachts before you accepted your new job. You are confident in management’s ability to lead the company. Analysis of the company has led to your belief that the company is growing and will achieve a greater market share in the future. You also feel you should support your employer. Given these considerations, along with the fact that you are a conservative investor, you are leaning toward investing 100 percent of your 401(k) account in East Coast Yachts. Assume the risk-free rate is the historical average risk-free rate. The correlation between the bond fund and the large cap stock fund is .16 1. Considering the effects of diversification, how should Sarah respond to the suggestion that you invest 100 percent of your 401(k) account in East Coast Yachts stock?
Considering the effects of diversification, Sarah should advise me to not invest 100 percent of my 401 (k) account in East Coast Yachts Stock. There are several reasons as to why Sarah should suggest that I invest my 401 (k) differently than I have proposed. The number one reason for me to invest differently is due to the high risk that I would be taking by investing 100 percent of my retirement plan in company stock. While Sarah would not discount my desire to hold company stock, she should rather suggest that I limit the amount of company stock in my 401 (k) to 10 to 20 percent rather than 100 percent.
Maintaining a portfolio with the stock of only one company is very high risk. This is because any fluctuation, positive or negative, will be felt directly in the value of the portfolio. In other words, by having a portfolio with the stock of only one company I would be risking everything on one endeavor (Schwanbeck, 2004). Instead, I would be further ahead to select other 401 (k) options in addition to company stock. This would allow for the value of my retirement plan to stay somewhat stable as stocks fluctuate at different rates, meaning that while one may rise another may fall and vice versa. Having a portfolio with a wide range of stocks minimizes risk.
Another issue that Sarah should advise me on in regards to putting 100 percent of my 401 (k) in company stock, is the lack of flexibility to change the portfolio for my retirement fund. What this means is that if I choose to put my entire retirement fund in company stock, then if the company has a blackout date where the stock cannot be touched, I cannot offload the stock if the value begins to slide (“Putting too much,” 2011). Additionally, the company may place other restrictions of the sale of company stocks, such as when it can be sold how it is sold etc.
Therefore, Sarah should encourage me to look into the other options that are available for my 401 (k), while keeping only a portion of the retirement fund in company stock. By putting a portion of my retirement fund in company stock I am still showing support to my new company while making the wise financial decision to minimize my risk.
“Putting too much stock in your company—a 401 (k) problem.” (2011) Retrieved from: http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/RetirementAccounts/p013381
Schwanbeck, M. L. (2004). Your 401 (k) handbook: 2004 employees’ guide to investments and decisions.Arlington, VA: Your Money Press