The lock-up at my company (LinkedIn) has come off, and I’m thinking about how to invest the proceeds from selling some of my shares. Is there an optimal strategy for investing my money into an asset allocation? Should I suddenly buy all at once or over a period of time? Psychologically, dollar cost averaging might make sense but I wonder if that is something people tell you so you sleep better at night and there is little scientific merit to it?
– A reader
Congratulations on the hard work that you and your colleagues put in at LinkedIn, which has put you in the position to ask this question.
People in your situation — those who own a concentrated stock position in the company where they work — worry about two questions regarding the position. First, whether to sell and second, how to sell.
You’ve already decided to sell some or all of your employee stock – which is most likely a wise choice.
Working in the company means that you are exposed to the risk that the company will stumble (any company faces that risk; I’m not making a particular statement about LinkedIn). Keeping a large part of your wealth in the company’s stock increases your exposure to that same risk.
When you sell, you can start building a portfolio diversified among different asset classes, in allocations that suit your risk level. (At Wealthfront, we suggest six asset classes: U.S. Stocks, Foreign Stocks, Emerging Markets, Real Estate, Natural Resources and Bonds, and we offer a risk assessment tool to help you decide your allocation).
Now we come to the second question, which is the focus of the post: How to sell? Should you sell all of the shares immediately or sell gradually over a period of time?
Generally, it’s smart to sell shares gradually, in order to limit what we call execution risk – that is, the risk that you will pick the wrong day to sell, when a stock is at a low point, or the wrong day to buy your new investments, when they are at a high point.
A gradual approach also gives investors a greater ability to control tax bills.
I’ll detail our rationales in this post, and, at the end, discuss a trading plan that may enable the sale of shares on a predetermined schedule, one that abides by the regulations that govern public company employees.
It’s extremely difficult to time the market or the performance of a single stock. If you decide to sell your shares on a day the price is at a high point, you win; if it turns out the price was at a low point, you lose out – maybe by a lot. Since you intend to reinvest the proceeds of your sale, you face this timing risk both in the sale and the purchase.
Unfortunately, it’s extremely difficult to predict the direction of future price movement. People who believe they have enough information or knowledge to time the sale of a stock usually do not. Employees, especially, may suffer from familiarity bias. (Here’s an article that defines it and one of our earlier posts that talks about familiarity bias and other mistakes investors make.)
By spreading the sales across time and executing at different price points, an investor effectively makes multiple smaller bets, is more likely to get a higher average price and thus has lower execution risk.
You can call it temporal diversification or dollar cost averaging. Whatever you call it – it may help you sleep better at night.
Controlling your tax bill
A gradual approach will also increase the chance that you’ll be able to control, and potentially, lessen, your tax bill.
We aren’t tax experts (and before you make a decision of this magnitude, we suggest that you do consult with one, who will consider both your personal tax situation and the kinds of options you have). But my thought process about why a gradual approach is better might help you as you seek out that advice.
You’ve probably accumulated a large position in LinkedIn’s stock by being an early employee when it was still a private company and being awarded stock options. Your LinkedIn position hence has very low cost basis, or even a close-to-zero cost basis. Most of the sales proceeds will be realized capital gains and taxable. If you sell the entire position or a big portion of the position immediately, you may trigger a seriously large tax bill, possibly including the Alternative Minimum Tax.
If instead you sell the position gradually over a number of years, you can spread your tax liability into different years.
By delaying the tax bill and putting the money to work, you effectively increase your principal and earn investment return on a larger pie.
Spreading the sales across a number of years may also give you the ability to actively manage your tax bills. If you have realized capital loss on the other stocks in your portfolio or earn less income in any given year, you may wish to sell more of your LinkedIn stock since your overall tax base (income and capital gain) is lower. You also might decide to sell less of your LinkedIn stock in a year in which your earnings are unexpectedly high.
How long a period of time?
If you do decide to sell the position gradually, how will you decide what that period of time ought to be? Should it be three years, five years or 10 years? It’s harder to give a generic suggestion because it depends on your personal situation. Our founder, Andy Rachleff, recommends selling 10% a quarter, because that’s what worked for executives of companies that he backed as co-founder and general partner at Benchmark Capital.
Here are some guidelines for you to consider as you think about your time frame.
– If you are more risk averse and nervous about the large concentrated stock position, sell faster
– If you have cash needs in the short time or mid term, sell faster
– If you decide to join another company and thus have less exposure to LinkedIn’s company risk, sell more slowly
– If you earn higher income thus higher tax base, sell more slowly
10b5-1 trading plan
Since LinkedIn is now a public company, most likely you are not allowed to trade during a time window around the company’s earning announcement. That regulation reduces your sales window and may complicate your divestiture plan. If you are an executive with access to insider information, you will have an even narrower sales window, restricted by earnings reports and major market-moving information. One solution to the problem is to establish a 10b5-1 stock trading plan, enabled under SEC rule 10b5-1 governing insider trading. A 10b5-1 stock trading plan is an automatic and configurable trading program that you set up in advance and let run without your intervention. For example, you can configure the plan to sell 100 shares every Friday at market-close price. The automatic trading plan allows corporate insiders to sell their shares at a pre-specified schedule without being liable to insider trading accusations, as long as they don’t possess insider information at the time they set up the plan. It conveniently takes the manual selling work off you, extends your sales window and protects you from regulatory risk.
Consider selling your LinkedIn shares gradually over a period of time, in order to reduce your tax bills and execution risk, such that you can sleep better at nights and continue contributing good work during the days at LinkedIn.
You may also be interested in a related piece we did: Should Volatility Keep Me From Investing?
About the author(s)
Qian Liu is the lead architect of Wealthfront’s algorithms and methodologies used to implement our portfolio management and tax-optimization software and develops much of our investor research materials. Before joining Wealthfront in 2009, Qian worked on trading and portfolio analytics at Credit Suisse. Qian is a CFA charterholder and member of the CFA Society of San Francisco. Qian earned her MS and PhD in Computer Science focusing on Machine Learning from University of Pennsylvania where she researched computational gene prediction using statistical machine learning models. She received her BS in Computer Science from Tsinghua University. View all posts by Qian Liu, PhD