Are reckless CEOs born or made?

I have written a tongue-in-cheek post about how men with a deeper voice have a higher propensity to take on risks and may thus not be the best choice to run a company. But there is a more serious side to this research that warrants mention.

One of the perennial discussions about CEOs of large corporations is their compensation. These days, their compensation package is not just very high, but often dependent on either stock bonuses or stock options. The difference between the two is of course that a stock compensation scheme works both ways. If the share price of the company declines, the CEO’s stock package declines in value. This is also true for the stock option plan, but once the options are far out of the money, the CEO does not face any more downside. Instead, the CEO has an incentive to take on more risks with the company. If the gambit works, the share price of the company recovers and the value of the stock options multiplies. If it doesn’t the company gets into real trouble but for the CEO that usually means leaving the company with a nice golden parachute.

And of course the same is true for hedge fund and private equity managers with a performance fee. If the fund is well below the high water mark, the fund manager has an incentive to take on excessive risks. If the risks pay off, he will get a ton of performance fees. If it doesn’t, he can simply close the fund.

The question, though, is if CEOs are taking on risk because they have a natural inclination to take on risks or because they are incentivised to take on these risks through stock option plans? Francois Desmoulins-Lebeault, Jean-Francois Gajewski, and Luc Meunier have tried to disentangle these two effects with 100 volunteers. The volunteers (53 women and 47 men) were asked to participate in different lottery-like games where they could choose between a safe and a risky option. In one version of the experiment, they were compensated with an equity-like scheme gaining 5% of their gains or losses. If the participants lost money with their risky decisions, they received a lower pay-out in the experiment. In the stock option version, they instead got 1% of their gains or losses (simulating a small equity plan) and 10% of the gains if they made any gains (simulating an at the money stock option). Hence they could still lose a little bit of their pay-out but mostly win big if their risky choices turned out to be profitable.

As usual, the volunteers were then asked how much they would need to win on average to switch from the safe choice to the risky gamble. The chart below shows that when compensated by stock option this risk premium was significantly smaller. Hence, the participants were more likely to take risks when paid with stock options rather than stocks.

Risk taking becomes more likely with stock options

Source: Desmoulins-Lebeault et al. (2020).

So far so bad, but what the study also tested was the testosterone and cortisol level of the participants and their influence on risk aversion in the same experiment. And it turns out that people with a naturally higher level of stress hormones not only are more aggressive in their investment decisions but that this genetic predisposition explains about eight times more of the variation between people than the contractual incentive scheme.

In other words, while incentives matter, reckless CEOs are mostly born that way and not prisoners of a bad incentive scheme. And that means that if a CEO ruins a company, we shouldn’t blame the compensation scheme, but the people who hired him in the first place. It is time we hold the board accountable for hiring the wrong CEOs.