'How much of my 401(k) should be in company stock?'

@Money May 2, 2012: 11:26 AM ET

(Money Magazine) -- I work for a Fortune 500 company that matches my 401(k) contributions in company stock, which I can then re-allocate to other investments every quarter if I wish. Given that I won't retire for several decades and I think my company has great growth potential, how much of my 401(k) do you think I should have in my company's stock? John, Minneapolis, Minn.

How do I put this? How about zero, none, nada, zilch.

Other than whatever shares of your company that might be owned by an index fund or other broadly diversified mutual fund that's on your 401(k)'s investment menu, I don't think you should keep a dime of your 401(k) in your employer's stock, regardless of how spectacular you may think the company's growth prospects are.

Why do I take this hard line? One reason is common sense. You've already got a lot of your financial security riding on your employer in the form of your paycheck. Investing in your employer's stock only compounds the problems you might face if your company runs into trouble.

Investment analysts have long known that people who concentrate their portfolio in an employer's stock -- or shares of any single company for that matter -- don't earn high enough returns to compensate them for the extra risk they take on by holding an inadequately diversified portfolio.

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Economist Lisa Meulbroek notes in "Company Stock In Pension Plans: How Costly Is It?" that "even employees who work for relatively safe 'blue chip' firms are significantly worse off by concentrating their wealth in company stock."

There are plenty of examples that illustrate the perils of loading up on company stock. The most famous is Enron, the energy firm that was the darling of the investment community until it collapsed in 2001, taking the 401(k) plans of thousands of employees down with it.

More recent high-profile corporate implosions, like that of Bear Stearns and Lehman Bros., also serve as warnings of why it's dangerous to have much of your wealth invested in your employer's shares.

And your company doesn't have to actually go belly up for you to get hurt, a fact I know only too well from personal experience. Even though I never voluntarily put a cent of my 401(k) dough in my employer's stock, I acquired a decent size stake of Time Warner shares over the years via matching contributions that I wasn't permitted to move. After the combination of the late '90s stock frenzy and the AOL Time Warner merger in 2000 sent the price of my company shares into the stratosphere, I found myself with a 401(k) that had roughly half of its value in employer stock I was locked into.

Unfortunately, as investors began to recognize just how disastrous this merger was shaping up to be, the price of my company shares began to plummet. Only when the stock neared the bottom of its more than 80% slide were plan participants given the option of moving out of our company shares. By then, the damage had already been done, in my case a loss of several hundred thousand bucks that's taken roughly a decade to recoup. Thankfully, the 2006 Pension Protection Act has since ushered in new rules that make it much easier for 401(k) participants to diversify out of company stock.

However, there is one scenario in which holding onto company shares in a 401(k) could make sense. If someone is closing in on retirement and has a big slug of employer stock that's been acquired at very low prices over the years, that person may qualify for a tax break known as "net unrealized appreciation," or NUA, by taking possession of the actual company shares rather than rolling them over into an IRA.

I want to emphasize I'm not suggesting anyone invest in company shares during their career to take advantage of this strategy. But if someone has already acquired a large amount of company shares with a low cost basis and is nearing retirement, then NUA is a move worth considering.

Even then, it's important to remember that this strategy has potential downsides even beyond the risk of having so much of one's wealth tied to a single stock.

Bottom line: I recommend you transfer out of company shares as soon as you're legally permitted to do so and spread the money proportionally among the other investment options you've chosen.

If you're so tempted by the growth potential of your employer's stock that you simply can't resist taking a flier on it, then at least minimize the potential damage by keeping your overall exposure to company stock, including your 401(k), stock options, stock grants, etc., to no more than 10% of your wealth.

Saving and investing for retirement is tough enough. Don't make it harder by engaging in a strategy that increases risk without a commensurate boost in return.

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