NEW YORK (CNN/Money) - I have 100 percent of my 401(k) invested in my company's stock. Since it's been doing really well recently, I've never bothered about diversifying. But with the recent Enron debacle and the fact other companies may be in line for accounting fraud issues, I'm concerned. Should I keep my money in my company's stock or should I pull out and diversify?
-- Peter Godwin, Fairfax, Va.
I've already weighed in on the topic of company stock in 401(k)s in a previous column. But since Enron-like accounting techniques seem to be popping up in other companies and because I'm not sure that even now many investors understand the true risks of loading up their 401(k)s with company stock, I thought I'd take another whack at this issue.
This time, however, I thought I'd try to explain why putting a big chunk of your money in your employer's stock -- or any single stock for that matter -- is a risky strategy.
The three kinds of risk
Basically, when you invest in a stock, you take on three types of risk. The first is market risk, which is the volatility a stock experiences as the result of the movement of the market overall.
The second type of risk is industry risk, which means a stock's fortunes will usually rise or fall along with those of whatever industry the company is part of.
The third type of risk is known as specific stock risk or "idiosyncratic" risk. This is the risk that your stock's price will fall because of some problem related specifically to your company.
It's impossible to get rid of market risk since that's an inherent feature of owning stocks. The best you can do there is to lower that risk by adding other asset classes, such as bonds or cash, to your portfolio. You can -- and should -- significantly reduce the other two types of risk, however.
By spreading your money among stocks in many industries, you can dramatically lower industry risk. Similarly, by diversifying your holdings among many stocks, you can really cut back on specific stock risk. If you own several dozen stocks in your portfolio you would have to be an incredibly bad or unlucky investor for most of them to have Enron-like problems.
Until recently, researchers believed that you could diversify away about 90 percent of specific stock risk by holding a portfolio of 20 or so stocks. But because individual stocks have on average become more volatile in recent years, researchers now believe you need 40 to 50 stocks to diversify away the same amount of specific stock risk. (If you've got the appetite for this sort of thing, you can read a study on this topic by clicking here.
To diversify or not?
Which brings us back to your question: Should you keep your money in your company's stock or diversify? There's no single answer for what level of company stock -- if any -- is appropriate in every case.
In general, I think most people are probably better off holding no more than 20 percent of their overall assets in company stock, but the percentage that's right for you depends on what other investments you have, how large a percentage of your overall net worth your employer's stock represents, your company's future prospects, what other sources of retirement income you have (Social Security, company pension, annuities, etc.) and, of course, your tolerance for risk.
But whatever decision you make, it should be made on the basis of the factors I just mentioned, not on the basis of how your company's stock performed in the past. After all, Enron stock was up 93 percent in 2000 -- and lost as much as 99.7 percent of its value in 2001.
Even if you decide to diversify, however, your plan may place restrictions on selling company stock your employer has contributed. For advice on that matter as well as other tips on diversifying a 401(k) that contains company stock, I suggest you click here to read my previous oeuvre on this issue.
One final note: one of the joys of retirement is engaging in activities you didn't have time to do while working. But that can be hard to do if you're destitute. So all things considered, I think you'd want to err on the side of caution with your retirement money rather than assuming outsize risk.
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