Over the years, there have been many studies about CEO compensation and risk taking with the data on outcomes derived from data available from public companies. The latest salvo comes from two professors, one from BYU and the other Penn State, who have published a new paper in the current issue of The Academy of Management Journal. They studied 950 companies from 1994 through 2000 and found that CEOs who recieved more than half their compensation from stock options were more likely to undertake risky investments to deliver extreme company performance. The problem is that these investments were more likely to end up in big losses than big wins.
Floyd Norris in the New York Times describes the conclusion that the study’s authors come to. Namely, CEO pay should include deeply in the money options and longer holding periods so that the CEO acts more like shareholders.
This may or may not be a good idea. What’s clear is that in the studied companies risk taking was at the discretion of the CEO. Companies apparently could not distinguish between good and bad risks to take, and the decision about whether to take them rested on the shoulders of the CEO. But this not need be the case. Better transparency into the state of risk into the business would have provided more sunlight on these so-called risky decisions. In the current climate of risk management focus, boards complain that they don’t have good visibility into the state of risk in the enterprise, and judging from this study, this lack of visibility is causing poor performance, with companies investing in areas with sub par returns for the chance of a big win. This bodes well for the risk management business.