An Actual, Lasting Lesson From LTCM’s 1998 Collapse

This month marks the 25^th anniversary of hedge fund Long-Term Capital Management’s (LTCM’s) implosion, sparking a litany of retrospectives on the meltdown, the Fed’s intervention and its legacy. One that caught our eye, stood out from the crowd and arguably has more lasting relevance for investors: LTCM founding partner Victor Haghani’s Financial Times op-ed reflecting on his decision to tie up a huge chunk of his liquid wealth in the fund—a holding well above and beyond his large ownership stake in the company. His conclusion? By not correctly accounting for his personal comfort with risk—in this case, the risk of both the fund and the value of the company going to zero—he had invested much more than he should have.^[i] It wasn’t ruinous, thankfully, but it is emblematic of a temptation and pitfall many investors face. Holding concentrated positions can seem attractive, especially when you work at the company in question. But the risks are great, and diversifying is almost always the better move.

For many folks working for publicly traded companies, it can be all too easy to rack up large positions in their employer’s stock. Usually, it isn’t a matter of getting hired by Widgets ‘R’ Us and then rushing to buy a boatload of Widgets ‘R’ Us stock to celebrate. It is typically more benign and almost accidental. Stock-based compensation is common, especially at bonus time, due to its favorable tax treatment. Some 401(k) plans incentivize the purchase of company stock, too. And startup employees who vest their options at the right time can find themselves with a big pile of company stock after an IPO.

If your company’s stock is going up and even beating the market, this can seem like a win-win. The company is paying you both in salary and with hot returns! But nothing lasts forever. Unforeseen competition, market shifts, bad investments, bad management and external disasters can change a business’s trajectory at warp speed. Hot returns could easily go cold … or to zero.

Yes, that is an extreme outcome, but it is a real one. It happened to so many Enron employees in 2001. When the accounting scandal erupted and culminated in the company’s rapid bankruptcy, over half the plan’s $2.1 billion in assets were in Enron stock.^[ii] Those holdings were wiped out, devastating workers and their families. Too many walked away with nothing. The story has repeated many times since, sadly.

But that won’t happen to me, you might say. I would see the problems coming and sell. Ideally, yes. Haghani thought he had unique insight into LTCM’s future, and he probably did. Employees could very well know the company better than outsiders. But employee stock is often restricted to certain selling windows, especially for executives. Enron employees who wanted to sell couldn’t because the company froze all 401(k) plan assets, forcing them to watch helplessly as their retirement savings plunged. Even when people are able to sell, personal guilt can kick in, a sense of I can’t hurt my company by dumping its stock during a hard time. And often it can simply be too late, with the stock declining before trouble becomes obvious as markets do their usual forward-looking thing. Even if the company doesn’t go to zero, factors outside your company’s control can affect relative and absolute returns—like industry competition, macroeconomic factors and more.

This is where using a more risk-focused framework can help. If you have a large position in your employer’s stock, it means you are relying on your employer for two of the biggest, most important financial inputs: Your salary and the compound growth of your savings. In other words, your entire financial security and future may depend on a single company, and if that single company fails, you could be out of income and retirement savings in the blink of an eye. Those thinking rationally will probably come to the conclusion that the magnitude of this risk is greater than the potential reward, not a beneficial tradeoff.

If you want to have a little financial ownership stake and interest beyond your salary, that is one thing. And we get that sale restrictions may mean you have trouble diversifying easily. But it is usually best to have a very short leash for any position, keeping maximum exposure at about 5% or so of your portfolio (or perhaps a little more if it is a ginormous company that represents more than 5% of global market capitalization). Beyond that, diversify—as soon as you can. Not only will it expand your opportunity set to companies that might have an even brighter future than yours, but it spreads around risk. Not just among different firms, but among a broad array of sectors, industries, countries and regions.

We see only one situation where it makes sense for someone to have a concentrated position in the company they work for: when it is their own business. Entrepreneurs and small business owners will typically have a huge chunk of their personal wealth tied up in the company. To you, we say, carry on and live your dream! We are talking about liquid net worth here, not illiquid assets like a business or a home. Whether or not you own a business, those liquid assets should be diversified in line with your goals, needs, time horizon and comfort with market volatility—not tied to a single company’s fortunes.