Facebook’s IPO is set to unleash a slew of new millionaires on the Bay Area. Granted, it won’t all happen at once. Most employees have to wait six months before cashing in their restricted stock units. But this is a good opportunity to highlight the dangers of technology IPOs. Simply put, they create instant wealth, often concentrated in a single position.
There are always some employees who know how to properly diversify, but most aren’t investment professionals. They typically invest in what they know, and what they know is technology. So even if the payout is predominately cash, as in Facebook’s case, a number of employees will still end up with technology-heavy stock portfolios. This is a dangerous game. Stock concentration can significantly increase portfolio risk, so whatever the situation, diversifying usually makes sense.
The Typical IPO Gamble
In a more typical situation, your company goes public, you exercise options, and the vast majority of your portfolio ends up in a single stock. What next? Holding the concentrated position is a big gamble. You may get lucky, but in reality the odds are against you. A study published in the Journal of Finance by Jay Ritter, Professor of Finance at the University of Florida, examined the performance of over 7,400 stocks following their IPOs from 1980 to 2009. While short-term performance was positive, longer-term performance was less than ideal. After three years, post-IPO stocks underperformed broader index firms by almost 20 percent. Granted, this number was pressured by company shutdowns during the tech boom and bust. But it still mirrors the trend in prior years.
So if chances are low you’re sitting on the next Google, what do you do? Diversify. Why plow your entire net worth, everything you’ve worked for, into a single bet? A bet with low odds, nonetheless. You’re already 100 percent dependent on this company for income. Why would you put your investment portfolio at risk too? Don’t get greedy. Diversification is the best way to reduce portfolio risk and secure your financial future.
What Does Diversification Actually Mean?
Diversification doesn’t mean spreading your wealth across a few different technology stocks. You should build a portfolio of multiple lowly or uncorrelated investments. A properly diversified stock portfolio should have exposure to all economic sectors, not just technology. The reason is simple: stocks in the same sector tend to behave more similarly to each other than to stocks in other sectors. So if technology blows up, your exposure to energy, health care, or utilities is there to act as a counterweight. Think about it. If you were entirely invested in technology in 1999, or financials in 2006, you would have lost over 80 percent of your portfolio value in the subsequent downturns. And this is despite having a fairly well-diversified portfolio of stocks within those respective sectors. Sector concentration can be just as risky as stock concentration.
And diversification shouldn’t stop there. You should aim for exposure across different styles, sizes, regions, and to the extent possible, sub-industries. Spread out your risk. Doing this reduces portfolio volatility and can actuallyimprove expected return. Greater return with less risk is the Holy Grail of investing. Ideally, each stock should only represent a small percentage of the aggregate portfolio. When positions get much greater than 5 to 7 percent, a portfolio begins to take on meaningful concentration risk.
But always keep in mind equities are just one component of building an investment portfolio. Studies show the most important driver of long-term returns is asset allocation. In other words, the percentage of your portfolio invested in higher level categories like stocks, bonds, alternatives, and cash. Unfortunately there’s no one-size-fits-all allocation. It depends entirely on your personal financial situation — your goals, your risk tolerance, and your assets. It’s probably the most important investment decision you’ll make, so consult a professional if you don’t feel up to the task.
Of course, congratulations are in order for all you Facebookers. Going public is a significant achievement and major milestone for any company. Be proud. Just make sure you’re ready when those RSU cash payments come your way. Have a plan in place, and make sure your investment portfolio is well-diversified. Don’t let something like stock concentration, or even sector concentration, ruin your newfound fortune.
This article first appeared on Forbes. Image via Forbes.