Many people who work for large, publicly traded companies are given the option to invest in company stock through their 401(k) plans.
There are a number of ways company stock can end up in your 401(k) plan. Some companies have incentives to encourage employees to purchase company stock—for example, you may be able to purchase the stock at a discount from the current market price, or your employer may offer a better matching contribution if your contribution goes to the purchase of company stock.
In addition, some employers that make matching contributions to 401(k) plans do so using company stock rather than in cash.
As a result, it is not difficult for investors working at these companies to wind up with a large percentage of their investment holdings in the stock of their employer.
The publicity surrounding the fall of Enron in 2001, and the enormous losses suffered by Enron employees who owned too much company stock in their 401(k) plans, caused many workers to think twice about investing heavily in company stock. But that was some time ago, and Enron memories are starting to fade. With the economy once again picking up steam, many employees are once again starting to load up on company stock with their 401(k) plans.
Is company stock a bad investment for your 401(k) plan?
There are upsides and downsides to owning company stock in your plan.
On the upside, there are of course any incentives that your employer is offering—these are hard to pass up. In addition, you most likely are very familiar with the condition of your company—if you work for a solid company that has strong growth potential, you could do quite well with the investment.
On the downside, you could, of course, be wrong about your employer's prospects, and your 401(k) plan would suffer. In addition, you are already dependent on your employer's future for your job security. If something were to happen to the company and you lose your job, it would only compound your loss if your 401(k) plan's value was affected as well.
Lastly, you should be aware of any restrictions in your ability to sell shares—some companies, for instance, may restrict your right to sell shares before you turn 50 or for some specific period of time.
Like many things in life, moderation is important. Investing in your employer's stock can be very risky if it becomes a large percentage of your 401(k) plan holdings. A diversified portfolio is key to your long-term financial security.
Poor diversification can result in a much higher-risk portfolio than you had intended. Further, the older you become (and therefore the shorter your investment horizon), the more risky a portfolio that is top-heavy in a single stock becomes.
A good rule-of-thumb is to hold no more than 10% of a portfolio in any one stock—including your employer's.
That would prevent the specific business problems of any one company or industry from having too much influence on your retirement portfolio, and it allows for adequate diversification among various stocks, significantly reducing risk.