Dealing with the Complexities of Non Quallified Options

I recently exercised some Non Qualified stock options, and am struck again by the complexities of the decisions surrounding options. These complexities seem to be little understood by most, and if my experience is typical, there is little in the way of documentation/explanation to guide the holder. So, let me relate what I've learned about the rules regarding options and my experience concerning how it affects the decisions you must make. As always, comments from the experience of others is welcomed.

When options are issued, they seem innocuous enough. There is no immediate effect on your taxes and the value is zero. If the stock price does not increase, they remain valueless. However, if, as in my case, the stock price appreciates, it leads to a number of nice-to-have, but none-the-less perplexing issues concerning when to exercise them. These issues, and their effect on your decisions are outlined below:

1. The value of options is extremely volatile. Options are more volatile than the stock by a factor of the current stock price divided by the difference between the current and the strike price. In my case, that means the options are 3-4 times as volatile as the stock price, which of course is likely already considerably more volatile than, say, a stock index fund. If the value of the options is low and you are still working, this may be a small issue. But, once you've retired and the value grows to a significant percentage of your portfolio, this begins to create a significant risk, despite the fact that the volatility has a huge upside if the price appreciates significantly. Incidently, running a standard set of assumed appreciation will always mean you are far ahead to keep the options until the last minute due to the leverage, so you have to consider whether the risk makes this worthwhile.

2. Dividends are not rec'd. If dividends are a significant part of the long term total return of the stock, as in my case, the fact that option holders do not receive the dividends becomes a drag on the investment as compared to owning the stock. If the price appreciates substantially, the leverage mentioned above more than overcomes this problem, but if not, the options suffer relative to other investment options.

3. Taxes. The proceeds for the exercise of options are taxed as regular income, including social security and medicare. If you are still working and the deadline for exercising is far away, it may be wise to hold in hopes of being in a lower tax bracket by the time you need to exercise and it is hard to justify triggering these high taxes any earlier than necessary. But, if you are retired and approaching the deadline, holding them exposes any future increase to regular tax rates and SS and Medicare, as opposed to alternative deployment of the capital. Other alternatives, such as index funds, expose any future increase only to much lower capital gains or dividend rates and allows you to time even this taxation to your best advantage over many years. And, it avoids the SS and Medicare taxes altogether on future gains. But, that must be balanced against the tax hit today.


So, where does all this leave you? With a jigsaw puzzle!! Generally, if you can see yourself with a lower tax rate prior to exercise deadlines and the value/volatility is not too high, it probably makes sense to delay exercise. If, however, the additional risk is an issue, and your tax rates are more or less steady through the period before your deadline, you may want to exercise early to minimize taxes on future gains. Even if your rates are otherwise steady, you'll need to evaluate the amount to exercise each year to avoid pushing yourself into a higher bracket by virtue of the exercise. My answer to this is to use a copy of TaxCut software to run a plethora of cases. This exercise may surprise you, as it did me, prompting me to sell more early on than previously planned. With all the complexities it is almost impossible to arrive at the best option without using tax software, although the ultimate answer almost always depends on your conviction about the prospects for the stock. If you're sure the price of the stock will move firmly upward, you can laugh all the way to the bank while holding the options as long as possible. Just keep in mind that this is a two-edged sword. You could be crying all the way to the poorhouse if the stock drops.

Great Investment in Home Conservation

I am constantly amazed at the opportunities for investments around the house, which have outstanding returns and are seldom recognized.

Last week, I was visiting my parents and my brother. The topic of insulation came up and we realized that both homes have minimum insulation in several areas. I volunteered to do an analysis of the cost/savings potential in adding some insulation.

For example, both homes are built in pier and beam style and have no insulation under the floor. Granted, ambient temperatures are moderated by the shade and air contact with the ground. But even after adjusting for this, the investment potential for adding insulation is outstanding.

One exposed area is approximately 1500 sq ft. I estimate this can be insulated with 6" of fiberglass at a cost of about $900. Meanwhile, I calculated the energy savings at over $500 per year. This is an annualized return of over 50% per year, essentially risk free. Compare that to the 5% they are getting on CDs these days! In fact, I challenge anyone to come up with an investment with this return and so little risk.

But wait, I can hear the protests...I don't have that kind of money laying around!! In that case the deal is even better. If you finance the $900 for 10 years at 10%, your monthly payment would be about $12/month. Since your average savings on utilities is about $43/month, you would end up with $31 in your pocket every month with no outlay. In less than 4 years you can pay off the note, have $900 in your account and still have the insulation, where it will save you $43/month for as long as you live in the house! You just can't beat that for an investment.

Financial Advisor? No Thanks!!

Many of my friends insist that a dedicated financial advisor is a necessity. I get the "If you needed brain surgery, would you insist on doing it yourself?" questions occasionally. Others insist they just don't have the time to do their finances justice. But, when I ask myself whether a financial advisor makes sense for me, the answer is clear...No, thanks!!

Personal finance is not brain surgery. And, you can be virtually certain of beating the market with as little as a couple of hours of preparation and setup and 15 minutes per month for maintenance. If you don't know how, spend half of your preparation time reading some of my previous articles on dollar cost averaging, diversification and rebalancing.

Admittedly, you'll beat the market averages by only 1-4%, while you could dream of wildly outperforming the market. But a small margin of outperformance will work miracles over the long term when combined with the power of compounding. If you can consistently outperform the markets by 2.5% over 40 years, your nest egg will be over 60% larger than it would have been just matching the markets.

And, using a financial advisor does not guarantee outsized returns. In fact, if he tries to justify his fees by trying to chase trends, or by using more sophisticated investments and frequent trading, I believe the likelihood of outperforming the markets is decreased. But, if you can outperform the markets, why couldn't the advisor do the same? He could, if he used the same methods! But, then his fees would eat up half the outperformance. And, why exactly would you pay him to do what you could easily do yourself with minimal effort?

Of course, there is the chance the advisor could be brilliant and dramatically outperform, but the chances of this are small. It amounts to whether you want to go to Vegas to seek your fortune or would prefer the near certain path to financial security. To me, the latter sounds more appealing. Perhaps this example sounds extreme, but I have heard numerous horror stories from colleagues about the results they obtained with their financial advisor. Remarkably, some of them still used the same advisor, or switched to a different one for similar service!! I can only conclude that gambling is indeed an addiction!

Of course, there are times when expert advice is needed, such as estate planning or second opinions on your strategies, and I've used advisors in these cases. But, I'd rather pay a few hundred dollars for the specific advice I rarely need than to pay a substantial percentage or fixed fee on a regular basis.