It is Blog 73, and it is my very first Blog as a self employed individual! In the 2 years that I have been writing and creating this content, this is the fist one that I am actually doing during the day on a Monday to Friday. It is the first time not writing either really early in the morning before 'the house' wakes up, or really late at night when the house is fast asleep!! It is lovely to be writing with the sun shining in the window, all I need to worry about now is making enough money to keep the house fed and watered!!
Luckily the schedule is pretty full for the next few weeks! I am embarking on a new venture, to have a hugely positive impact on how financial advice is done, and on the impact it has for regular people like you and I here in Ireland. It will be a sweet adventure, which will no doubt have many twists and turns but as Socrates once supposedly said 'The unexamined life is not worth living'!
Anyway, we're not hear to hear about me, we're here to help you. And this week in Ireland's dedicated Financial Planning & Personal Finance Blog & Podcast we take a look at what has been my worst investment ever, but also my greatest lesson as an investor. I am an open book, and happy to share this with you, in the hope it may help others avoid the same mistake! It revolves around a company share scheme that I was involved in 10 years ago, and a cheque which I received last week for a grand sum of €0.26 (yes 26 cents!) which was what I got back, in total, having previously invested almost €10,000! Here's how it happens.
Share Option Schemes:
Share option schemes are a great vehicle to avail of tax efficient shares in a company that you work with. There are various forms of these schemes; Profit Sharing Schemes, Share Options and a Key Employee Engagement Programmes. Each essentially offers an employee an opportunity to purchase shares in the company they are working for. This is an attractive route for many, as typically, the employee can buy the shares with Gross Income (before-tax). The impact of buying them with Gross Income is that the employee buys the shares and pays no income tax on the money which you use to buy the shares!
For example, suppose your gross income in a month is €6,000. You have an option to buy €2,000 worth of shares in your company through a share scheme. If you don't buy the shares and instead opt to take the €6,000 as income you'll pay full tax on that income, and for arguments sake you'll get €3,000 into your pocket. If however, you do avail of the share scheme you get the €2,000 of shares into your name instead of half of that portion being taxed. Depending on the scheme you will be eligible to sell the shares in a few years time, and get the €2,000 (or whatever they are worth when you sell!) tax free into your pocket. This means that you have perfectly legally avoided (which is very different to evaded!) paying income tax on the portion of income which you used to buy shares through the Share Option Scheme.
Is It Worth Doing A Share Option Scheme Through My Employer?
From a tax efficiency perspective they can be pretty superb. To be able to forgo a portion of income, divert it to shares in the (hopefully growing) company that you work for, and then to be able to cash the shares in for tax-free cash in say 3 years time, is a significantly better financial outcome than taking that money as taxable income. If you do not need the money then it is a very attractive opportunity. What can make it even more attractive is that the shares might well increase in value during the period in which you hold them. You may also decide not to sell them in 3 years, instead holding them for a long period of time, selling them in the future only when you need the funds. In that period of time the share price may have doubled, tripled or indeed increased in value significantly more. When this happens it is definitely a positive outcome, and people are delighted to have done it. Alas, it does not always work out this way!
What Are The Risks Of Buying Shares In The Company I Work In?
As great as the above may sound there is one major and unavoidable risk in this strategy. It is important to first outline, again, the difference between risk and volatility! Risk is the chance of you losing your entire capital investment, while volatility is the degree of ups and downs in the value of your investment.
By buying shares in your company you are taking a risk. There is a chance, no matter how successful your company, no matter how much it is growing, no matter how convinced you and your peers are that your company is only going to go from strength to strength, no matter how long it has been in existence, or how much of a monopoly it has in it's industry or sector, there is a risk that it will not exist in the future.
PanAm Airlines was the largest international air-carrier in the US, Irish Life & Permanent was one of Ireland's leading banks with a share price at over €20, Enron had over 20,000 employee and generated revenues of over 100billion dollars in 2000, Woolworths was one of the largest retailers in US, Lehmans had been established for over 150 years and was the 4th largest investment bank in the US. These house-hold names, these really high performing companies, with loyal and confident employees do not now exist. Anyone that bought shares in them now hold share certificates that are of little or zero value. The risk that they would lose their capital invested has come true. There are countless other companies that people have invested in that may still exist but which are shadow of their former selves in terms of share price. A dear friend of mine worked with a company here in Ireland for nearly 30 years, bought shares in the company every year, had built up a fund that would be a huge asset and enable her to live a dignified life in retirement, however that pot of money is now less than 10% of it's value at the peak. The risk is just too high.
If you look at the company you may be working for, and one in which you hold a significant portion of shares, how would you react if it started losing it's value, or indeed if it totally collapsed and ceased to exist in 5 years time? We all hope this doesn't happen but it is going to happen someone again in the future. It is by investing €10,000 into one of the earlier-mentioned companies, and receiving a cheque of €0.26 which is what my €10,000 is now worth, that I have learned my greatest investment lesson. Some would say it is a cheap lesson.
How Could You Lose €10,000?
You may, quite rightly, ask 'how on earth does someone like you, who is meant to know what they are doing, lose €10,000'!? Fair question, I'd ask the same myself! It is so easy happen, you can get blinded to the risks when a company you work for is doing so well, you can forget the fact that an investment of a considerable portion of your wealth in a single company/share is an extremely un-diversified and risky approach to investing. That is a fact, and one which is lost on very many people here in Ireland.
When I made the investments over 10 years ago I was watching the share price climb continuously, I was hearing about my peers who had bought the shares every year, at really low prices in comparison to where they were at the time, sure I'd be mad not to buy some, it'll take care of the college fund etc etc! In conjunction with the tax relief available in purchasing them through the scheme it was a no-brainer and away we went!
It was very shortly after I made these investments that the share price started to tumble, but you still never figure that the company is essentially going to disappear! If that was a realistic prediction at the time I (along with my peers) would surely have cashed in the shares, and paid the tax that would have been payable, just to get something from it. But most of us held our ground, awaiting good news and a recovery of the share price, which never happened. I am grateful for this lesson, it has helped me, and indeed many many people that I have subsequently assisted with their own investment portfolios, to avoid the risk that is associated with investing in a single company, no matter how great a company it is.
An Alternative View?
We have consistently shared the idea that diversification is a key component in developing a portfolio that stands a chance of delivering a successful financial outcome for investors. Buying shares in a single company is so far removed from diversification that it can't be seen! If investing in companies is what someone seeks then diversification can be achieved in spades by investing in an Index Fund. Index Funds as we have covered before invest in quite literally thousands of companies. The risk of losing your capital when invested in thousands of companies as opposed to investing in 1 company is how much lower do you think?? It is night and day. As far as I am aware no well diversified Index Fund has lost all it's capital. In order for that to happen the 1,000 or so companies that it holds would need to ALL go bankrupt. There is always a chance that that could happen, but how likely is it.
Y,es Index Funds will fall in value, it is only around the corner, based on historical average it should have happened a few years ago! However unlike a share in the above named companies, the value of a holding in an Index Fund has always recovered and gone on the greater highs....it is part of the constant upward curve that we have shared on several occasions.
Share Option Schemes are attractive to many due to the tax relief. They are attractive to many due to the fact that they like their companies and want to won a piece of them. They feel optimistic about the future values of the shares. By all means these are valid reasons. They are reasons however that lead people to be heavily exposed to 1 share, a share in the same company that also happens to be their source of income! For many that risk has proven to be too great, and they literally paid dearly for their lack of diversification.
Thanks for reading,
You're a legend!
QFA |RPA | APA | Qualified Coach