Diversification and Employee Stock Option

Employee stock option is the option given to an employee by a company, to buy stocks of the company at a particular price in the future. ESOP is usually given to employees to boost their morale by giving ownership in the company, which is linked to their performance. The reason behind ESOP is that the employee will work hard to improve the performance of the company, which in turn will improve the company’s share price. ESOP has gained more importance in the past decade because of the tax incentives which it got, when compared to bonuses. But in the recent past this advantage has reduced by the imposition of taxes by the government.

Diversification is the process of reducing(hopefully) your risk in savings by investing in wide range of products. The range of products should be negatively correlated with each other so that when one investment reduces in value the other will increase, thus giving a cushion against losses. Diversification is considered very important to avoid the pits of short and medium term fluctuations in the markets.

Now the question in everyone’s mind is “What is the connection between employee stock options (ESOP) and diversification?” One can consider the time they spend in their job as an investment, and the salary they get as return for the time. Since employee spends at least one-third of his time in his job, this assumption becomes very important. Also in the same line, the salary increments and the promotion that the employee expects can be considered as the future expectation from the investment. So when an employee is investing almost one-third of his life in the company, is it a prudent decision to invest his savings also in the same company? Isn’t this against the basic reasoning for diversification?

I am not telling that ESOP is bad for everyone. But care should be taken when one accepts ESOPs. The terms and conditions under which the ESOP is given should be scrutinized before exercising the option. Employee should not be lured into the hype around ESOP and accept it. He should consider it as another of his investment and try to take an informed decision. ‘Overconfidence’, one of the key concepts in behavioural finance, is one of the biggest hurdles that the employee has to overcome to take an informed decision. The employee thinks that he knows a lot about his company and is overconfident about its returns. But rarely does anyone knows about the real status of the company, other than the top management (good example for this is Enron). Think of a situation in which the company goes bankrupt, the employee looses both is job and his savings, which is a catastrophe for any employee.

Therefore an employee who believes in diversification should be very careful before he accepts his ESOP.

I will be happy to discuss about any difference in opinions regarding the above view . Looking forward to many interesting discussions.