CEO personal investment decisions and firm risk

Published date01 October 2017
Date01 October 2017
CEO Personal Investment Decisions
and Firm Risk
Wei Cen
HSBC Business School, Peking University, Shenzhen, 518055, China
John A. Doukas
Strome College of Business, Old Dominion University, Norfolk, VA 23529-0222, USA
We develop a novel method of measuring CEO risk preference based on their
personal allocation of deferred compensation funds, and nd CEOs holding more
volatile deferred compensation portfolios lead riskier rms. We also use the 2008
nancial crisis as a natural experiment to check the robustness of this new method
and nd consistent evidence in support of a positive association between CEO risk-
taking and rm risk. Moreover, the evidence shows that risk-taking CEOs pursue
risky nancial and investment policies. Our results, in accord with the behavioural
consistency theory, demonstrate that CEOs act consistently across personal and
professional choices.
Keywords: CEO deferred compensation, CEO risk preferences, financial crisis,
firm risk, inside debt
JEL classification: G30,G32,G34,M52
1. Introduction
How does chief executive ofcer (CEO) risk aversion affect rm risk? Answers to this
important question remain divergent. While traditional nancial theory suggests that
rms should simply pursue positive net present value projects to maximise shareholder
The authors thank an anonymous referee for helpful comments and suggestions, Phil
Berger, Andy Bernard, Marianne Bertrand, Alan Bester, Yaniv Grinstein, Chris Hansen,
Chang-Tai Hsieh, Rafael La Porta, Mark Leary, Christian Leuz, Jon Lewellen, David Ng,
Abbie Smith, Doug Skinner, John Thanassoulis, Naqiong Tong and Jerry Zimmerman. All
errors, omissions, and conclusions remain the sole responsibility of the authors and do not
necessarily reflect the views of the organisations with which they are associated.
European Financial Management, Vol. 23, No. 5, 2017, 920950
doi: 10.1111/eufm.12117
© 2017 John Wiley & Sons, Ltd.
wealth, some argue that heterogeneous objective functions are being maximised (e.g.,
Allen, 2005). More recent studies stress the importance of managerial heterogeneity.
Unlike previous studies, this paper addresses this question using a unique set of executive
deferred compensation plan (DCP) data that allows us to develop a novel approach of
inferring CEO risk preferences from their deferred compensation investment decisions.
The objective of this study is to understand the forces driving rms exposure to risk by
analysing whether corporate investment and nancial decisions are consistent with
CEOspersonal investment choices. To our knowledge, this is the rst study to gauge
CEOsrisk attitudes directly from their personal deferred compensation investment
decisions and examine how they relate to rm risk. This is also the rst study that
documents the investment performance data of executive deferred compensation, which
is an important executive compensation instrument and often studied as a part of
executive inside debt (Cassell et al., 2012; Sundaram and Yermack, 2007; Wei and
Yermack, 2011), but has been overlooked in the literature even though it was disclosed in
Managerial styles and risk preferences vary across CEOs. The prevailing perception in
academic research is that CEO personal risk preferences tend to affect rm risk and
performance through the implementation of different policies (Lewellen, 2006;
Schooley and Worden, 1996). While CEO risk preferences are not directly observable,
the literature considers two possible indirect measures of managerial risk preference:
CEO compensation schemes and CEO personal characteristics. However, the
methodology of using executive compensation as a measure of risk aversion is based
on risk-neutral valuation. To the extent that CEO risk-aversion decreases the value of
compensation (e.g., stock options), this approach may yield inaccurate estimates
(Lambert et al., 1991). Moreover, endogeneity among managerial incentives, risk and
performance makes this methodology even noisier (Low, 2009; Palia, 2001).
Alternatively, prior literature has used managerial personal characteristics (such as
age, personal income, wealth, education and gender) to estimate managerial risk aversion
(e.g., Bajtelsmit and Bernasek, 2001; Donkers et al., 2001; Grable, 2000; Wang and
Hanna, 1997). However, critics argue that rm history and previous CEO characteristics
are irrelevant and may not be a good proxy of talent and risk preferences in their current
employment environment (Wang, 2009).
To avoid the risk-neutral assumption, endogeneity, and irrelevance problems in the
previous literature, we focus on variables that allow us to quantify CEOscurrent risk
aversion more accurately. Specically, we develop a new method to assess the risk
tolerance of key corporate decision-makers and show how it relates to rm risk.
Furthermore, we supplement our inferences about the relationship between CEO risk
preferences and rm risk by examining the nature of nancial and investment decisions
pursued by CEOs. Our approach is based on the behavioural consistency theory (Epstein,
1979; Funder and Colvin, 1991) which states that people act consistently across personal
and professional states. Hence, we deduce CEO risk-aversion by focusing on the
For example, Bertrand and Schoar (2003) document managerial xed effects, Malmendier
and Tate (2005, 2008) nd managerial overcondence proxies that relate to rm behaviour,
and Kaplan, Klebanov, and Sorensen (2012) report that CEO characteristics in private equity
rms are related to outcome success.
© 2017 John Wiley & Sons, Ltd.
CEO Personal Investment Decisions and Firm Risk 921

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