CEO personal investment decisions and firm risk

• Published date: 01 October 2017
• Date: 01 October 2017
• DOI: http://doi.org/10.1111/eufm.12117

CEO Personal Investment Decisions

and Firm Risk

Wei Cen

HSBC Business School, Peking University, Shenzhen, 518055, China

E-mail: wcen@phbs.pku.edu.cn

John A. Doukas

Strome College of Business, Old Dominion University, Norfolk, VA 23529-0222, USA

E-mail: jdoukas@odu.edu

Abstract

We develop a novel method of measuring CEO risk preference based on their

personal allocation of deferred compensation funds, and find CEOs holding more

volatile deferred compensation portfolios lead riskier firms. We also use the 2008

financial crisis as a natural experiment to check the robustness of this new method

and find consistent evidence in support of a positive association between CEO risk-

taking and firm risk. Moreover, the evidence shows that risk-taking CEOs pursue

risky financial 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 officer (CEO) risk aversion affect firm risk? Answers to this

important question remain divergent. While traditional financial theory suggests that

firms 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, 920–950

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.

1

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 firm’s exposure to risk by

analysing whether corporate investment and financial decisions are consistent with

CEOs’personal investment choices. To our knowledge, this is the first study to gauge

CEOs’risk attitudes directly from their personal deferred compensation investment

decisions and examine how they relate to firm risk. This is also the first 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

2006.

Managerial styles and risk preferences vary across CEOs. The prevailing perception in

academic research is that CEO personal risk preferences tend to affect firm 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 firm 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 CEOs’current risk

aversion more accurately. Specifically, we develop a new method to assess the risk

tolerance of key corporate decision-makers and show how it relates to firm risk.

Furthermore, we supplement our inferences about the relationship between CEO risk

preferences and firm risk by examining the nature of financial 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

1

For example, Bertrand and Schoar (2003) document managerial fixed effects, Malmendier

and Tate (2005, 2008) find managerial overconfidence proxies that relate to firm behaviour,

and Kaplan, Klebanov, and Sorensen (2012) report that CEO characteristics in private equity

firms are related to outcome success.

© 2017 John Wiley & Sons, Ltd.

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