Developing an exit strategy for employee stock options in a bear market

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Stocks are down this year, pretty much everywhere. Unfortunately, some businesses will not survive the recession. Even for those who do, a return to historic Covid-era highs is far from assured. For employees with stock options or shares held, it may be time to reassess your selling strategy and expectations. Especially for employees of companies IPOs last year, valuations have fallen significantly. Even though the stock price has fallen, there may still be time to consider diversification.

Selling Stock Options in a Bear Market: The Dangers of Anchoring Expectations on Past Performance

When the Federal Reserve effectively set interest rates at zero, it forced investors to seek returns other than bonds, inflating the value of many risky assets like stocks. As a result, many companies that went public in 2021 did so at very optimistic prices. In fact, newly listed companies are down about 45% since the start of 2021 (Renaissance IPO ETF). Many stocks of seasoned companies were also trading at record highs, before sentiment started to turn in the fourth quarter of last year.

For employees with concentrated wealthit may even be difficult to consider sell now, knowing what once was. Whether or not to sell depends on many factors specific to your situation. Consider your concentration relative to other assets, company fundamentals, growth prospects, liquidity, need to raise more funds, etc.

When weighing the pros and cons, it’s important to consider or reconsider your expectations and whether they justify the price you’re aiming for. Some stocks will never return to their all-time highs, no matter how much time passes. If the company was trading at an inflated price due to market conditions at the time, then it will be much harder to justify that valuation when the exuberance subsides.

Individual stocks vs market

Historically, on average, the S&P 500 has finished the year with gains about 75% of the time. But this concerns the 500 largest publicly traded companies – not only a. There’s a significant amount of scatter inside that. Especially for newer and smaller companies, the risk and volatility are higher. Of course, the goal is to increase the upside potential, but the focus is on potential.

Here are some sobering statistics on the performance of individual companies:

  • How many individual stocks remain public and outperform the market?¹ About 35% over rolling five-year periods, 29% over 10 years and 21% over 20 years.
  • The stock has fallen so much that it has to get up from here.² Bad. Past performance (whether good OR bad) is not indicative of future results! Between 1947 and 2020, stocks that That is outperformed Where have underperformed the market over the past 20 years, only 30% would have outperformed as a public company over the next 10 years.
  • Big losses are common.³ Between 1980 and 2020, nearly 45% of all companies that have ever featured in the Russell 3000 Index experienced a 70% price drop from the peak and never recovered. When looking at the distribution of lifetime excess returns of individual stocks relative to the Russell 3000, the median underperformance was almost -10%.

Deciding when to sell stocks even if the price is lower

Especially for early adopters or founders, you likely still have significant gains despite current valuations. It is therefore worth asking when exercise and sell stock options or long stocks even if the stock is down. Turning paper profits into realized gains is part of building wealth. Diversifying a concentrated stock position is the way it is done.

When you have a large stake and the stock price drops, it’s easy to try to replace it on Monday morning. Rather than lamenting the actual events of the past (which you cannot change), apply them to your forward thinking.

Imagine you own a stock and the current market value is $1 million

Maybe the stake was worth $2 million last year, maybe even $5 million. But now it’s worth a million dollars. You’re not happy selling at the current price, but wondering if you should. Present your baseline, best and worst results.

Here is a hypothesis:

  • Base: sell today for $1M
  • Better: the stock goes up 50% and you sell for $1.5M
  • Worse: the stock loses 50% and you sell $500,000

Is the potential best-case scenario worth the risk of the worst-case scenario? The answer will be different for everyone.

You can even go further.

Consider assigning probabilities to the likelihood of each outcome. You have to make an educated guess, but it can help you navigate the decision tree. As a simple example, if there is an equal probability that the stock will either up or down 50%, then the million dollars it’s worth today is probably a risk-adjusted fair value.

Sounds drastic, but remember the many stats shared earlier. Newly listed companies are down nearly 50% on average, and bouts of underperformance don’t mean a rebound is inevitable.

Diversification strategies

Selling an asset is not a decision to be taken lightly. And tax implications, concentration, risk tolerance and other factors should always be considered. Taking some risk on the table does not necessarily mean selling 100% of the position at once. Diversification strategies can include dollar cost averaging, limit orders, new price targets, or even the use of options on your options (like a cashless necklace).

Like the rest of the decision, the alternatives will vary in terms of availability and desirability. And because every situation is different, selling may make sense in some cases and not in others. But if you don’t ask the question, who will?

Past performance is not indicative of future results. or for informational purposes only and should not be misinterpreted as personalized advice of any kind or a recommendation for any specific investment product, financial or tax strategy. This is a general communication and should not be used as the basis for making any type of tax, financial, legal or investment decision.

¹ Source: dimensional, based on CRSP and Compustat data. The US market includes all US common stocks with no gaps in monthly data for a given rolling period. Stocks delisted with a delisting code between 200 and 399 are considered good delistings; incorrect write-offs are greater than or equal to 400. Outperformance defined against the value-weighted market at each cross-section. The statistics reported are averages calculated over rolling multi-year periods formed monthly from the cross-section of stocks available at the beginning of that month. Rolling monthly periods between January 1927 and December 2020. Article

² Source: Dimensional, based on data from CRSP and Compustat. Includes all US common stocks. Stocks delisted with a delisting code between 200 and 399 are considered good delistings; incorrect write-offs are greater than or equal to 400. Stocks with full monthly data for 20 years prior are classified as outperforming and underperforming relative to the value-weighted market. 10-year survival and outperformance defined against the value-weighted market at each cross-section using stocks with no gaps in the following 10-year monthly data. Survival, outperformance and bad write-offs are averages calculated over rolling 10-year periods formed monthly from the cross-section of stocks available at the beginning of that month. Rolling periods of 10 years between January 1947 and December 2020. Article

³ Source: JP Morgan Private Bank. 1980-2020. Article.

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