An Equity Compensation Holder’s Marshmallow Test

By AnnaMarie Mock, Highland Financial Advisors

​Walter Mischel, psychologist and professor at Stanford University conducted an experiment in the 1960s about delayed gratification and published his findings in 1972. In the study, a researcher explained to a child they could either have one marshmallow immediately or two marshmallows if they waited 15 minutes. The results varied; only a few children managed to wait 15 minutes and get the second marshmallow.

Follow-up studies continued for 40 more years where the children who waited had higher test scores, lower substance abuse issues, and better social and life factors. This proved that delayed gratification and an individual's success are tied to ‘nature’ and a person’s inherent ability.

Fast forward to 2012, researchers at the University of Rochester redesigned the marshmallow experiment to incorporate two groups. The first group was exposed to unreliable situations. For example, a child was given a handful of crayons and told they would receive better art supplies if they waited, but the researchers did not fulfill their promise. While the children in the ‘reliable group’ received the art supplies as assured. After that, the researchers conducted the original marshmallow experiment with each child. The findings were staggering – children in the unreliable interactions ate the marshmallow 4x faster than the reliable group.

These studies taught us that the environment influences delayed gratification as much as inherent ability. In other words, nature and nurture play into how we interpret and respond to information. Employer stock options are a perfect example of mandatory delayed gratification and the need to display restraint during the investment time horizon.

Stock options typically come with a vesting schedule extending upwards of six years. Until the options vest, employees do not have the right to sell or exercise them, which means the price may go up and down without the ability to act. The real test for equity compensation holders comes after vesting when there are a few paths to take - sell immediately, retain stock, or ignore it altogether. Like the ‘unreliable group” impacted by the nurture aspect, investors face uncertainties and no guarantees when investing in the markets. It’s human nature to withdraw oneself from a situation that exerts stress and precariousness because the prospect of losing principal frightens investors.

This is especially relevant for equity compensation holders with sweat equity in their company where the stock price may not reflect their dedication and personal success. Investors who react during down markets may feel like there will never be a recovery because they’ve been burned before and are influenced by past experiences. They’d rather retain some value in their assets than leave them at the mercy of the markets.

When the outcome is uncertain, investors flock to what feels safe and create their own stable environment by turning to riskless investments, not reacting, or frivolous spending. There’s a cost to responding that way, though. Let’s use the stock price of a global pharmaceutical company over the past 30 years. The highest price was about $89, while the lowest was about $24, meaning the median price is $56.50. That’s quite a large spread! The price history is anything but smooth too. The stock price during the 2000s was more than cut in half after the peak in 2001. The current price is reminiscent of 2001, but it took over 20 years for the price to rebound. The price pattern over the last 30 years may have shaped people’s decision-making through past experiences.

The end result for individuals may be the same, but the path to get there can be completely different. For example, an employee with vested equity compensation that maintained their stock during the rise and fall through the 2000s saw their investable wealth significantly fluctuate. Like the ‘unreliable’ group, they may act now based on fear and skepticism that this current 2022 value cannot be sustained based on prior events. While an employee may have sold during the lows of the 2000’s thinking there would never be a rebound from the lows of 2010, now feel as though this is their chance to recoup some of the growth they missed.

There are two things the individuals above have in common:
(1) they did not have an established plan for their options
(2) they reacted based on prior experiences and emotions rather than evaluating unbiasedly.

Whether it’s a waiting period of 15 mins or 15 years, watching the ebbs and flows of the market is part of the process. A long-term investor that is patient, has a strategy, and separates money from emotions will have a successful outcome over time. Rather than relying on a generic approach, we recommend working with a financial advisor to analyze your stock compensation with your long-term financial plan in mind and create an actionable plan while being mindful of your investment style (nature) and prior investment horizon (nurture).  The most challenging part is executing the plan; however, this dynamic process will reduce your stress about money, support your current needs, and build assets for long-term goals.

Disclaimer: The foregoing content reflects the opinions of Highland Financial Advisors, LLC, and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions, or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful or that markets will act as they have in the past.