Investing
Zoe Team and Bill Rackley, CFP® (Zoe Network Advisor)
6 min read
Evaluate opportunity cost before making high-risk, high-reward financial decisions.
Diversification helps reduce portfolio risk and aligns with long-term financial stability.
Concentrated stock positions increase volatility risk and may not suit every investor’s goals.
It is the potential gain you miss out on when choosing one financial alternative over another.
Diversification spreads risk across multiple assets, reducing the impact of volatility on your overall portfolio.
If predictability isn’t your priority and your financial plan allows for it, you may choose to seek higher potential returns.
High-risk, high-reward decisions are complicated. Understanding what investment decisions align with your financial plan and unique situation is critical. Without one being better than the other, your decision might look completely different than your peers. So how should you evaluate what determines which path you take?
You’ve probably heard about the importance of evaluating the opportunity cost of your decisions – every time you make a choice, you should think about what you miss out on given alternatives. High-risk, high-reward decisions are complicated. Without one being better than the other, your decision might look completely different than your peers. So how should you evaluate what determines which path you take?
Let’s think about a situation we’d all like to confront. What would you do with those earnings if you won a raffle of $100,000?
There isn’t a size that fits all, but a specific size might suit you.
Imagine for a moment –
Shannon and Eric meet whenever they can, although less often than they would like. Last week, they met at their favorite lunch spot. Without knowing, they arrived in time for the restaurant’s quarterly raffle. To their surprise, their names were shouted across the room as they enjoyed their meal. Shannon and Eric agreed to share the total earnings, pocketing $100,000 each!
Since the winnings were substantial, a tax withholding was taken from the payouts, leaving the colleagues with $70,000 each. They walked out after enjoying a great meal with fruitful returns. As they agreed on the next rendezvous, they asked one another what they would do with their earnings.
Shannon spent the car ride home thinking about the amount she had just earned ($100,000) and the percentage she had to pay in taxes (30%). Let’s consider how this could relate to equity compensation.
Evaluating the tax payment led her to think it would be best to convert the tax remaining $70,000 to cash via option exercise. Since she had already paid taxes on the total earnings, there wouldn’t be any extra liabilities at this time.
Including these earnings in her investment portfolio would help decrease risk rather than lead to exponential growth (in that case, the added risk would be justified). Consequently, she allocated the winnings to her already diversified portfolio, where she focused on long-term goals and risk reduction through that diversification.
Simultaneously, Eric stopped at the office before returning home and decided to take a different route with his earnings.
Hint: Eric’s decision involves more risk.
He pondered on his knowledge about the company he’s worked at for over a decade, thought about the gossip of the company’s future success, and evaluated the legendary fortunes he could make through long-term ownership of the company stock.
After careful consideration, Eric used his post-tax $70,000 earnings to buy an equal amount of his company’s stock. Eric’s investment was a great example of familiarity bias. He invested in a company he knows well, which, in his mind, helped reduce the overall risk of his investments.
If you can’t decide whether you’d make a decision similar to Shannon or Eric’s, assessing the risk vs. reward associated with both sides of the story is a good start. Both actions could make sense depending on the context around them.
Notice a parallel between Eric’s choice and the nature of stock option compensation, or in this case Non-Qualified Stock Options (NSOs). NSOs are employee stock options where you receive a specified amount that vests (becomes available) over time. Like the raffle example, taxes are triggered with this type of stock option compensation, so deciding to receive NSOs includes awareness that an amount will be subject to taxes. In other words, Eric already paid the initial tax from the raffle earnings ($30,000). By investing in NSOs, he must acknowledge an additional risk from these stock options.
Shannon seeks to achieve the expected return of her portfolio with the new funds. She rightfully expects to complete the attributes of their designated portfolio mix going forward. Furthermore, access to the assets would match her anticipated needs.
However, Eric is positioning himself to take on more risk in terms of volatility because, by investing $70,000 in employee stock, he has ‘all of those eggs in one basket.’ Intuitively, this can lead to explosive upside gain or loss.
It is not the case that one choice is right and the other is wrong, but rather that both individuals have different evaluations and expectations of their investment’s risk and return.
Both approaches could be feasible – if one’s financial position suggests that predictable growth should be prioritized, then diversification is likely the best option. Meanwhile, If predictability is not the priority, the risk associated with holding a concentrated position could be the best choice.
Your risk vs. reward analysis should support the ultimate goal of making your assets work for you and your financial goals. Financial planning can help determine when to make a specific decision and how that aligns with your goals.
Arranging your finances in a manner that supports your life goals requires perspective. Are you a seeker of higher risk and its related reward, or do you feel that a less exciting path of risk reduction is more important for your future plans? Either can be determined by engaging in the process of creating a solid Financial Plan. Then you can know where you stand relative to your life goals and confidently make decisions as life presents options and opportunities.
Disclosures: Zoe Financial, Inc. ("Zoe Financial") is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. Zoe Financial provides investment advisory services and access to independent registered investment advisers through its platform. The information provided by Zoe Financial is for educational and informational purposes only and should not be construed as personalized investment advice or as an offer to buy or sell any security. All investments involve risk, including possible loss of principal. Past performance is not indicative of future results. Clients should consult with their own financial, tax, or legal professionals before making any investment decisions. The material presented by Zoe Financial is for informational purposes only and is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy, or investment product. Material presented has been gathered from sources believed to be reliable, however Adviser cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Past performance is no guarantee of future results. Zoe Financial does not provide legal or tax advice, and nothing contained in these materials should be taken as legal or tax advice. SEC Registration does not constitute an endorsement of Zoe Financial by the SEC nor does it indicate that Zoe Financial has attained a particular level of skill or ability. The sole purpose of this material is to inform, and it in no way is intended to be an offer or solicitation to purchase or sell any security, other investment or service, or to attract any funds or deposits. Investments mentioned may not be appropriate for all clients. Before making any investment, each investor should carefully consider the risks associated with the investment, as discussed in the applicable offering memorandum, and make a determination based upon their own particular circumstances, that the investment is consistent with their investment objectives and risk tolerance. Lower expenses do not guarantee better investment performance. Certain information contained herein may constitute forward-looking statements. Due to various risks and uncertainties, actual events, results or the performance of a fund may differ materially from those reflected or contemplated in such forward-looking statements.
