My 1st Million At 33 – yes, you can do it too

When people construct a pie chart of one’s networth picture, or stock portfolio, the percentage on leveraged positions is often not expressing the right view in my personal opinion.  Putting a percentage based on the current market value of the leveraged positions may be misleading for the following reasons:

1. When the upside leverage is very big, but the actual market value of the leverage is small, as often in the case in stock options, you may be diversifying out of a gold pot like Rag 2 Riches did in comment#12 of my MyTwoMillionsAt28 dot com article.  You should read about all the fine details in How to deal with company stocks & options on the proper ways that I personally advise for diversifying out of your company stock.
2. Vice versa, when the leverage goes in the reverse gear, your potential loss is much greater than what the actual market value indicates.  When you plot out the pie chart using just the market value of your leverage, you won’t realize how big the potential loss can be.  An example would be a house bought at the top of market, putting very little down payment.  Obviously, not just the down payment is at risk (assuming that the person is ethical.  Unfortunately, one of the reasons for housing boom/bubble is that it’s a market of head I win, tail you or the bank lose).

Okay, so what is my way of plotting out or putting a percentage number on the leveraging positions, such as house with a mortgage, stock options, ESPP.  Essentially, I will plot out everything by its full CONTROLLING market value, instead of the net value.  Then I will plot out the corresponding debts or commitments as negative percentages.  Obviously since pie chart cannot really show negative percentages, I don’t think pie charts should be used.

Let me use the following example that has the following financial components:

1. A $500K market value of house, with $400K mortgage debt.
2. 10000 shares of employee stock options of strike price at $100, with stock price currently trading at $120.
3. A covered call transaction: Bought 1000 shares of stock XYZ, but sold 10 contracts of calls (equivalent to 1000 shares) at the strike price of $120.

Okay, so here is how I would treat each:

1. I will enter 2 entries $500K as house, and negative $400K as debt into my portfolio picture.
2. I will enter $120 * 10000 shares = $1.2 million as stock option investment, and an optional negative $1 million as long as the stock trades above option strike price.
3. This is slightly complicated.  If XYZ is more than $120, I will enter a fixed amount of cash gain resulted from the trade.  If XYZ trades less than $120, I will enter a stock investment of 1000 shares * XYZ price.

Looking at those optional pictures are not easy.  But the most important thing is when you put together all the positive entries as they really are, you can see the full market effect on your portfolio & networth.  In #1, when house appreciate/depreciate 10%, its effect is 10% * $500K, not 10% * the equity of ($500K – $400K).  In #2, when the company stock goes up or down by 10% from $120, its full effect is 10% * $1.2 million, not 10% * $200K which is the current option value.  And in #3, when XYZ trades less than $120, XYZ will keep exerting its full effect of 1000 share * XYZ price.  On the other hand, once it’s above $120, there is no additional benefit, and you can only book the $120 * 1000 shares XYZ = $120K as cash and dead cash which you cannot use until XYZ is called away from you.

Now comes the really tricky part, I will use the total networth as 100%.  In the above case, assuming XYZ trades at $110, #1 has $100K, and #2 has $20 * 10000 = $200K, and #3 has $110K.  The total networth is therefore $310K.  But plotting out the portfolio, for #1, I will use  $500K / $310K = 161% house, and negative $400K / $310K = -129%, and #2,#3 are similar.  Why is that I will use 161% for the house in my portfolio plotting?  Because it means that suppose house value goes down by 10%, your total networth will go down by 161% * 10% = 16.1%.  The treatment of the house at 161% gives a much better picture than, if you simply plot the house equity of $100K in your portfolio.  Similarly for the stock option, plotting $1.2 million / $310K networth = 387%.  What does that 387% mean?  It means that if your company stock goes up by 10%, your networth will immediately go up by 38.7%, but also, if it goes down by 10%, your networth will also go down by 38.7%.  Scaling everything to networth, and putting a more meaningful percentage on the leveraged positions will give you a much better and clearer view on how each position can really affect your networth.