If your employer offers an employee stock purchase plan (ESPP), you have the opportunity to buy your company's stock in periodic intervals and in many cases buy them at a discount. But there are some strategies you can use to further maximize the benefits of your ESPP. That's going to be the focus of this article.
We'll cover these strategies in detail below, but first, let's give the ESPP a proper introduction.
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What is an Employee Stock Purchase Plan (ESPP)?
An ESPP is a plan that may be offered by publicly traded companies to its employees which allows them to purchase the stock of the company.
How Can You Maximize Your ESPP?
Take Advantage of the Discounted Stock Price
Many ESPPs offer their employees the ability to buy shares of the employer at a discount. A common discount is 15%, although the discount amount can vary.
Dollar Cost Average Your Purchases
Some ESPPs allow employees to make stock purchases through automatic payroll deductions. This is a perfect way to dollar cost average, which is the strategy of investing a fixed amount of money in the same stock each period, whether that is a week, month, quarter, etc. In this case, it would be every pay period.
This allows you to buy more shares when the stock price is low and less shares when the stock price is high.
Use a Long-Term Buy and Hold Strategy
A long-term buy and hold strategy may be an attractive option because you are snapping up shares at a bargain price (assuming you have the 15% discount) and letting the natural tendency of stocks to rise over time do its thing.
Also, you are protecting yourself against downside risk if you have the fairly standard 15% discount, because the stock would need to move down 15% before you take a loss on it. It's a great margin of safety to have when you are a long-term investor.
Or Use a Quick Sale Strategy
If you want to take advantage of the 15% discount but do not want to hold the stock long-term, you can choose to sell the stock as soon as you can after you purchase it.
There may be a lag between when you buy and when you can sell, so you may not be able to capture the full 15% discount when you sell, but you may also wind up with a greater profit if the price moves higher in the interim.
This type of “quick sale” strategy is attractive because there is an almost guaranteed profit. You are taking most, if not all, of the risk of loss off the table and locking in a guaranteed gain.
But there could be drawbacks or limitations to this approach as well. Your particular ESPP may have restrictions on when you can sell and if you are exposed to certain sensitive and potentially market-moving information about your company (usually applies for executives), there may also be black-out periods that may prevent you from selling the stock when you want.
Also, there could be some tax implications because the gains from a quick sale could be viewed as short term capital gains and be subject to a higher tax rate than if you had bought and kept it for the long-term.
Take Advantage of the High Contribution Limit
A final advantage of ESPPs is that you can often contribute a healthy amount to it each year.
We typically see a $25,000 purchase limit on the amount of stock you can buy each year through an ESPP. This is calculated based on the pre-discount price.
Beware of Concentration Risk
One thing to consider when evaluating participation in an ESPP is concentration risk. If you are using the “quick sale” strategy discussed above, this should not really apply, but if you holding for the long term, you may be taking on a high level of risk because you are investing money into a single company (which will likely be far more volatile than investing in an index fund, for example).
On top of that you are also employed by that same company, so if it suffers a meaningful setback (including potential failure), not only could your stock value be decimated, you could lose your job and your health insurance as well.
Basically, you may be risking too many eggs in one basket.
When the option was available to me, I took advantage of the 15% discount and chose to hold it for the long-term despite the concentration risk. That made more sense for me because of the superior tax treatment and because the bulk of my investment portfolio was not in my ESPP.
Regardless of which method you think is better, that discount is very hard to ignore.
As with all investment-related topics on this blog, please consult your tax and financial advisors before making any investment decision.