Question

Most companies’ 401(k) retirement plan has one more investment alternative beyond the stock portfolio, bond portfolio, and money market deposits: the company’s own stock.

Many employees like to invest in the company’s stock because they are so familiar with the company. We tend to think of familiar things and being better, which for many, means the higher expected return and lower risk. Of course, now that you have a financial education, you know that higher expected return does not come with lower risk—just the opposite: it comes with higher risk!

Nevertheless, most employees perceive the stock of their employer company to be a lower-risk investment. For example:

A survey asked: “Which is more likely to lose half of its value, your firm or the overall stock market?”

• 1,000+ responded
• only 16.4% stated their company

A survey to Vanguard pension clients asked: “Would you say your employer’s stock is MORE RISKY, LESS RISKY, or has ABOUT THE SAME LEVEL OF RISK as an investment in a diversified stock fund with many different stocks?”

• 33% of respondents felt that their Employer’s stock is riskier
• 39% felt that their Employer’s stock has about the same risk as a diversified stock fund, and
• 25% of respondents felt that investing solely in their employer’s stock was less risky than investing in a diversified stock fund

How far off are people's viewpoints? Consider the concepts of firm-specific risk vs portfolio risk? Which one is more real? What are ways to measure the risk of the firm vs the risk of the portfolio and how do we educate people on this?

Answer 1

Only the respondents (33%) who feel the investment in a single firm is more risky than investing in a portfolio are correct and the others are wrong. Firm specific risks or unsystematic risks consists of operational risk such as lowering of efficiency of the machines in terms of outputs, financial risk such as financial leverage in terms of both long and short term debts and also sector specific factors. These risks are of course not applicable to a portfolio because at a macro level these sector specific or firm specific risks are nullified.

For example a fall of crude oil price can cause the revenue of the companies in Oil and Gas sector to fall but on the other hand this reduces the operating cost of airline companies hence there stocks will give a better return and compensate eventually. This is how a portfolio diversification works and reduces the unsystematic risk by keeping the expected return same but reducing the volatility hence the risk.

The different ways of measuring operating risk of a firm are:

• Fixed Cost to Variable Cost ratio
• EBITDA margin
• Production capacity utilization or Efficiency

The different ways of measuring financial risk of a firm are:

• Debt to Capital Ratio
• Interest Coverage Ratio
• Debt to Equity ratio

The different ways of measuring risk of a portfolio are:

• The total volatility of an index or the VIX
• The Value at Risk of the portfolio
• The Expected Shortfall
• Sharpe Ratio