When you’re thinking about how to select investments in your 401(k) account, there are often many options to choose from. Most of these are diversified mutual funds that each contain hundreds or thousands of stocks or bonds (or sometimes both). Many companies, however, also include a much less diversified investment option in their 401(k) plans: stock in the company itself. It’s an investment option that’s best avoided.
Lots of people (though certainly not everyone) like company they work for, so it may feel good to invest in your employer. This can be especially true when the company is doing well, since both the price of the stock and your income from your job are more likely to rise. But if the company starts doing poorly, the stock price and your income could decline at the same time, hurting both your paycheck and your portfolio. In other words, owning stock in the company you work for reduces the diversification of your wealth.
A classic example of this situation was Enron, the energy company that went bankrupt in 2001. Enron employees held nearly 60% of their retirement assets in company stock, which was wiped out as the company collapsed. Thousands of employees, many unaware of the risk they were taking, lost both their job and their retirement savings.
Enron is an extreme example: few companies will collapse in such spectacular fashion, and only having a small portion of your 401(k) in company stock isn’t likely to devastate your portfolio. Still, as a rule of thumb, it’s better to avoid such concentrated investments, especially when their performance may be connected to your income from your job.