You’ve probably heard about the importance of evaluating the opportunity cost of your decisions – every time you make a choice, you should think about what you miss out on given alternatives. High-risk, high-reward decisions are complicated. Without one being better than the other, your decision might look completely different than your peers. So how should you evaluate what determines which path you take?

Let’s think about a situation we’d all like to confront. What would you do with those earnings if you won a raffle of $100,000?

There isn’t a size that fits all, but a specific size might suit you.

Imagine for a moment –

Shannon and Eric meet whenever they can, although less often than they would like. Last week, they met at their favorite lunch spot. Without knowing, they arrived in time for the restaurant’s quarterly raffle. To their surprise, their names were shouted across the room as they enjoyed their meal. Shannon and Eric agreed to share the total earnings, pocketing $100,000 each!  

Since the winnings were substantial, a tax withholding was taken from the payouts, leaving the colleagues with $70,000 each. They walked out after enjoying a great meal with fruitful returns. As they agreed on the next rendezvous, they asked one another what they would do with their earnings.  

A Road with Two Paths

The Path to the East

Shannon spent the car ride home thinking about the amount she had just earned ($100,000) and the percentage she had to pay in taxes (30%). Let’s consider how this could relate to equity compensation. 

Evaluating the tax payment led her to think it would be best to convert the tax remaining $70,000 to cash via option exercise. Since she had already paid taxes on the total earnings, there wouldn’t be any extra liabilities at this time. 

Including these earnings in her investment portfolio would help decrease risk rather than lead to exponential growth (in that case, the added risk would be justified). Consequently, she allocated the winnings to her already diversified portfolio, where she focused on long-term goals and risk reduction through that diversification. 

The Path to the West

Simultaneously, Eric stopped at the office before returning home and decided to take a different route with his earnings. 

Hint: Eric’s decision involves more risk.

He pondered on his knowledge about the company he’s worked at for over a decade, thought about the gossip of the company’s future success, and evaluated the legendary fortunes he could make through long-term ownership of the company stock. 

After careful consideration, Eric used his post-tax $70,000 earnings to buy an equal amount of his company’s stock. Eric’s investment was a great example of familiarity bias. He invested in a company he knows well, which, in his mind, helped reduce the overall risk of his investments. 

What Path Would You Take?

If you can’t decide whether you’d make a decision similar to Shannon or Eric’s, assessing the risk vs. reward associated with both sides of the story is a good start. Both actions could make sense depending on the context around them.

Risk vs. Reward

Notice a parallel between Eric’s choice and the nature of stock option compensation, or in this case Non-Qualified Stock Options (NSOs). NSOs are employee stock options where you receive a specified amount that vests (becomes available) over time. Like the raffle example, taxes are triggered with this type of stock option compensation, so deciding to receive NSOs includes awareness that an amount will be subject to taxes. In other words, Eric already paid the initial tax from the raffle earnings ($30,000). By investing in NSOs, he must acknowledge an additional risk from these stock options.  

Shannon seeks to achieve the expected return of her portfolio with the new funds. She rightfully expects to complete the attributes of their designated portfolio mix going forward. Furthermore, access to the assets would match her anticipated needs.  

However, Eric is positioning himself to take on more risk in terms of volatility because, by investing $70,000 in employee stock, he has ‘all of those eggs in one basket.’ Intuitively, this can lead to explosive upside gain or loss.  

It is not the case that one choice is right and the other is wrong, but rather that both individuals have different evaluations and expectations of their investment’s risk and return. 

The Intersection 

Both approaches could be feasible – if one’s financial position suggests that predictable growth should be prioritized, then diversification is likely the best option. Meanwhile, If predictability is not the priority, the risk associated with holding a concentrated position could be the best choice. 

Your risk vs. reward analysis should support the ultimate goal of making your assets work for you and your financial goals. Financial planning can help determine when to make a specific decision and how that aligns with your goals.

Your Next Steps

Arranging your finances in a manner that supports your life goals requires perspective. Are you a seeker of higher risk and its related reward, or do you feel that a less exciting path of risk reduction is more important for your future plans? Either can be determined by engaging in the process of creating a solid Financial Plan. Then you can know where you stand relative to your life goals and confidently make decisions as life presents options and opportunities.