The recent corporate scandals at several large, publicly traded firms such as Enron and WorldCom were particularly devastating for many employees of these firms, who had invested their retirement assets heavily in company stock. Such behavior is a clear violation of diversification principles - one study finds that the additional risk associated with investing in company stock has an average cost equivalent to 42% of the stock's value. Yet despite the risks, such behavior is common - more than 50% of retirement assets are invested in company stock at many firms, and more than 80% at some large firms including Procter & Gamble, Anheuser-Busch, and Pfizer.
Many firms encourage employees to hold company stock by making matched contributions to retirement accounts, or 401(k)s, in stock and in some cases by restricting employee's rights to sell this stock for some period of time. Yet employees ultimately determine the role of company stock in their portfolio via two decisions - how to allocate their own contributions across the available investment options (including company stock) and whether to reallocate their 401(k) holdings at any point in time.
In Employees' Investment Decisions about Company Stock (NBER Working Paper 10228), James Choi, David Laibson, Brigitte Madrian, and Andrew Metrick focus on one factor that is likely to affect employees' investment decisions: past returns on the company's stock. Specifically, the authors ask whether plan participants are momentum investors, who invest more in company stock when the stock has recently done well and less when it has done poorly, or contrarian investors, who do the opposite. The authors use changes in stock returns at three large firms from 1992 to 2000 to identify the effect of returns on the investment decisions of 94,000 plan participants.
The authors begin by offering a snapshot of the average plan participant at these firms. This employee has a 401(k) balance of $89,000, of which 18% is invested in company stock and 46% is invested in other equities. The employee makes a voluntary contribution of 8.7% of salary to the 401(k) plan, and one-tenth of that contribution is directed to company stock. Six years after enrolling in the plan, 80% of participants have changed the allocation of their contribution among the various asset classes or made a reallocation of their assets between asset classes (a "trade"). Very few participants make more than one trade every two years.
The authors first examine participants' decisions to allocate part of their payroll contributions to company stock when they first join the plan. They find that a higher return on company stock over the past year is associated with allocating more of the contribution to company stock and less to other equities, with the amount allocated to all equities unchanged. Thus, company stock returns have a mostly compositional effect on overall equity contributions. Interestingly, higher returns on the S&P 500 Index have a very similar effect.
Next, the authors examine participants' decisions to change the allocation of their payroll contributions. They find that higher returns on company stock lead participants to shift more of their contribution into both company stock and other equities. By contrast, higher returns on the S&P 500 Index lead participants to reduce their contribution to company stock and raise their contribution to other equities, with the total share in equities rising. Overall, the authors conclude that participants are momentum investors when making decisions about investment flows.
Finally, the authors examine participants' decisions to rebalance their portfolios by making trades among the various asset classes. They find that high returns on company stock induce participants to sell company stock and buy other equities. Thus participants are contrarian investors when making trading decisions, rebalancing their portfolio away from company stock when the stock has done well.
Persistent high returns on company stock over time will result in a 401(k) account that is heavily weighted towards company stock, absent action by the plan participant to rebalance the portfolio. The authors' findings suggest that this concentration of 401(k) assets in company stock will be exacerbated by participants' tendency to increase the share of their contributions allocated to company stock when the stock is doing well, but is also mitigated by participants' tendency to rebalance their portfolio away from company stock.
-- Courtney Coile