Bad Bets: Excessive Risk Taking, Convex Incentives, and Performance

Rui de Figueiredo (), Evan Rawley () and Orie Shelef ()
Additional contact information
Rui de Figueiredo: Haas School of Business
Evan Rawley: Columbia Business School
Orie Shelef: Stanford Institute for Economic Policy Research

No 13-002, Discussion Papers from Stanford Institute for Economic Policy Research

Abstract: Managerial incentives influence risk-taking as well as effort. Theoretical research has long considered risk-taking to be a potential side effect of incentive pay, but empirical analysis of risk-taking incentives has been more limited. This paper uses exogenous variation in incentives to examine how convex incentive schemes simultaneously influence performance and risk-taking. We study these questions in the context of the hedge fund industry in which the use of convex incentives is replete, given that most managers earn a combination of a base and an incentive fee if their performance exceeds a threshold. Consistent with other results in the literature, the paper first establishes that when managers fall below the threshold, above which they earn performance fees, risk-taking increases and performance drops. On average, risk-taking increases 50% and performance falls 2.3 percentage points when a hedge fund is below the incentive threshold.Having established these baseline results, the paper proceeds to more carefully examine the link between performance and risk-taking explicitly. First, given the empirical setting, we are able to separately identify the effort and risk-taking effects of being below the incentive threshold, and show that much of performance declines are due to excessive risk-taking rather than to reduced effort. Second, we show that risk-taking behavior is non-monotonic; managers who are significantly below the threshold reduce risk-taking relative to those who are relatively close. The importance of risk-taking to performance adds to the debate about the impact of incentives on behavior. Regardless of whether incentives are given or justified by concerns of moral hazard with respect to effort or risk-taking, or concerns of adverse selection or whether risk-aversion is an important consideration, risk-taking can have significant impacts. These results suggest that risk-taking, due to convex incentives, is not only inefficient-in the sense that risk-taking choices are dominated and lead to absolute performance declines.

Date: 2014-01
New Economics Papers: this item is included in nep-cta, nep-hrm and nep-sog
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