Inside Information and the Own Company Stock Puzzle

Abstract

U.S. investors allocate 30–40% of their financial asset portfolio in the stock of the company they work for. Such a portfolio flies in the face of standard portfolio theory, which prescribes that an investor should hold less of a financial asset that is positively correlated with her undiversified labor income. Nevertheless, we propose a rational explanation that prescribes a long position in own company stock. Precisely because the own company stock is positively correlated with the investor's labor income, any information the investor learns about her earnings is a partial information advantage in her own company stock. When confronted with a choice of what information to acquire, employees may choose to learn about their own firm. Learning lowers the employee's risk of holding own-firm equity, which raises its risk-adjusted returns and makes a long position optimal. (JEL: F30, G11, D82)