“The investor’s chief problem – and even his worst enemy – is likely to be himself.”
– Benjamin Graham
We all strive to make the best decisions when it comes to investing. While investment decisions generally result in an action (buy/hold/sell), investors tend to spend very little time understanding why they make those decisions.
We may think our decisions are based strictly on analysis, but science tells us otherwise. The study of behavioral finance reminds us that human nature likely plays a role in our decision-making. We are all subject to irrational beliefs that subconsciously influence our decision-making process. The key is to acknowledge these inherent imperfections in our decision-making and use them to our advantage.
Corporate executives are not immune to behavioral biases when making investment decisions. These biases uniquely influence corporate executives who receive a large portion of their compensation in the form of company stock.
It is important to keep in mind that executives do not purchase the stock in an equity grant; they do not make an active decision to acquire those shares. Instead, these executives’ only active decision is whether to hold or sell an equity grant. Executives may not recognize how this fact subconsciously affects how they perceive and manage their stock holdings resulting from equity grants.
The behavioral biases that impact the effective management of equity awards take several forms:
Imagine a scenario where you receive a cash bonus of $500,000 in lieu of Restricted Stock Units (RSUs). Would you immediately go to the market with your bonus proceeds and purchase company stock? The answer is almost invariably, “no.” However, few insiders elect to immediately sell vested RSUs. Instead, they tend to accumulate shares over time. The behavioral bias at work in this scenario is the status quo bias.
Status quo bias occurs when we prefer to keep things as they are by doing nothing or by sticking with a previous decision, even when we have access to new facts. Maintaining the status quo may be the path of least resistance, but it is not a sound, long-term strategy for managing equity awards. It is important to remember that doing nothing is still a decision.
Executives may also avoid selling their company stock holdings to avoid losing out of future gains. “I can’t sell now. The stock is making a move!”
This bias reflects the desire to avoid regret associated with selling a stock too early. When a stock has performed well, recency bias influences investors to believe it will continue to do so moving forward. The fear of missing out (also known as FOMO) on future gains can be overwhelming. FOMO can intensify when colleagues boast about inflated price targets from Wall Street analysts.
Anchoring is cognitive bias in which an individual depends too heavily on an initial piece of information when making decisions. This may occur when analysts publish their price target for the stock: “Analysts are calling for $50/share. If the stock hits that price, I’ll sell for sure!”
Anchoring can occur based on information from a variety of sources. In addition to analyst price targets (no matter how arbitrary), anchoring can also stem from recent stock price high-water marks, stock option strike prices, and even round price levels.
We don’t act on behavioral biases because we want to. We can’t avoid them - they are part of our human DNA. However, when managing equity awards, it is important to be aware of these biases in order to lessen their impact on decision-making. Working with an advisor is a good way to gain an objective perspective before making decisions about equity holdings. An advisor can help clients recognize what may be driving their decision-making and help guide them toward a more objective path to success.
If you have any questions about managing your equity holdings and stock-based compensation, please contact Blue Chip Partners. We are here to help you get the most life out of your wealth.
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