Lesson 4: Risk

Making the most of your options, making sound decisions about what you should do with them, requires a good understanding of the risks of owning them. There are basically two kinds of risk:

• Investment Risk, which deals with the risks of owning options as an investment. The study of investment risk asks the question, "How likely is it that my investment will go up or down in value?"
• Personal Risk, on the other hand, is asking the question, "What will happen to me, if my options go down in value?"

Investment Risk

One of the cardinal rules of investing is that you cannot separate risk and return. The high potential return of owning your options only comes with high risk. No discussion of investment return is ever complete without an examination of the risk(s) involved. Risk is what distinguishes an "investment" from "savings." As was true in Lesson 2: Income Taxes, the subject of investment risk can be very complicated and there have been many books written about it. In this lesson, we will only be giving you an introduction to the basics as they pertain to your stock options.

The investment risks of owning stock options are the same as those for investing in the stock of your company, except that those risks amplified by leverage (see Lesson 3). So when you think about the investment risk of your options, think about the risks of investing in the stock of your company and then think BIGGER or MORE.

Every investment in the stock of an individual company comes with these risks:

• Market Risk - This is the risk of investing in the stock market in general. The stock market as a whole will rise and fall over time based upon investors' collective view of how desireable it is to own an investment in stock. Your company may be doing poorly, but the value of the stock is going up because the stock market in general is going up. Conversely, your company may be doing very well, but the value of the stock drops because of inflation, rising interest rates or some other factor which is causing investors to prefer another type of investment. All stocks are affected by market risk.
• Industry Risk - This is risk that affects all companies in a certain industry. Utility companies, for example, are often viewed as relatively low in risk because the utility industry is a mature industry operating in a predicatable environment with relatively little change. In contrast, internet and other technology industries are usually viewed as high in risk because the industry is changing so quickly and unpredictably. All stocks within an industry are subject to industry risk.
• Regulatory Risk - Virtually every company is subject to some sort of regulation. Regulatory risk is the risk that the government will pass new laws or implement new regulations which will dramatically affect a business.
• Business Risk - Refers to the risks unique to an individual company. Products, strategies, management, labor force, market share, etc., are among the key factors investors consider in evaluating the value of a specific company.

Measuring Investment Risk

Financial professionals measure risk in terms of volatility. Volatility is determined by how much a stock price changes. Low risk investments have very little price change (a savings account, for example, has no price change). The stock of a small internet start-up company, on the other hand, will often experience wild swings in price, a high degree of volatility, and would be regarded as a high risk investment. A statistical device called standard deviation is generally used to measure volatility.

Understanding the risk of your options involves understanding just how risky the stock of your company is. You can evaluate the relative risk of your company's stock by comparing its standard deviation with that of other companies or the market as a whole over the same time period. Remember that leverage amplifies this volatility, making your options inherently more risky than the stock itself. (see Lesson 3)

Managing Investment Risk

Diversification is the most important tool for reducing investment risk. Owning other companies helps to reduce business risk. Owning companies that are affected by different types of regulation reduces regulatory risks. Owning companies in different industries reduces industry risk. And owning other types of investments, investing in bonds and real estate, for example, reduces the market risk of investing solely in stocks.

Of course, there is a cost to managing risk through diversification. That cost is a lower potential rate of return. You no longer have the potential to reap the extremely high rate of return that comes with owning a "home run" stock. But you also no longer have the risk of losing everything if the stock goes down, due to any one or all of those risk factors.

Reducing the Investment Risk of Your Options

So, to reduce the risk of your options:

1. Exercise Your Options - In Lesson 3, we explained how leverage amplifies the risk of owning options. So the first step in reducing risk is to exercise your options. Owning the stock, rather than options, will eliminate the risk amplifying leverage inherent in the options. And,
2. Diversity Your Portfolio - Once you exercise your options, your "portfolio" will likely consist of just one stock, the stock of your company. Selling the stock and reinvesting the proceeds in a diversified portfolio of stocks and other assets will reduce the risk of your portfolio.

Remember: Reducing risk and maximizing returns are opposing strategies. If you want to maximize returns, you need to hold on to your options as long as possible.

Can you reduce risk without giving up the wealth maximizing potential of your stock options?

For many the answer is, "Yes!" While reducing risk and maximizing returns are opposing strategies, they can be balanced by:

1. Exercising some of your options and using the proceeds to create a diversified investment portfolio, and
2. Holding on to the balance of your options to maximze after-tax return.

How many options should you exercise and how many should you hold?

You should exercise enough to eliminate your Personal Risk (or reduce it to an acceptable level, see below). Then you can afford to hold the rest for maximum gain.

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Personal Risk

So what's "Personal Risk?" While Investment Risk deals with the technical risks of your options as a type of investment, Personal risk deals with understanding how a loss in the value of your options will impact you personally, asking the question, "What will happen to me if the value of my options goes down?"

One of the biggest mistakes made by owners of employee stock options is thinking, "Because I haven't "paid" anything for my options, I don't really have anything to lose." That's one of the most damaging fallacies around. The truth is:

The net, after-tax value of your vested options is REAL MONEY!

It may not feel as real because it didn't take you years of saving to build, but it is just as real as money in the bank. Can you afford to lose it?

What's Critical Capital™? That's what Lesson 5 is all about!

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