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More options, more losses

Filed in archive executive pay by leon on October 16, 2007

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Loading up CEOs with options leads to riskier performance, according to new research.

A study, Swinging for the fences: the effects of CEO stock options on company risk-taking and performance , found that options loaded CEOs were more prone to extreme performance, resulting in big gains but more usually, big losses. In forms with high stock optionlinks pay, the proportion of cases with big total shareholder return losses was 10.1 per cent, while only 6.8 cases had big gains. Similarly when it came to return on assets, it was 6.9 per cent extreme losses versus 3.9 per cent gains. All up it makes for what the authors call a "combustible combination".

According to the researchers, W. Gerard Sanders of Brigham Young and Donald Hambrick of Pennsylvania State University, the problem with giving CEOs too many options is that it blinds them to potential losses.

"Because options-loaded CEOs benefit from share price increases but lose nothing if share prices drop, they can be expected to sort investment alternatives while paying little attention to the likelihoods or magnitudes of losses,'' they write. "If we accept the commonsense idea that the projects with the biggest possible upside are likely also to have biggest possible downside, and then couple it with the assumption that option-loaded CEOs have little concern with the size or probabilities of downside outcomes, it is straightforward to expect that option-loaded CEOs have a relatively high likelihood of delivering big losses."

So for investors, the lessons learned are clear: look at how the CEO is being rewarded before pumping your money into a stock.


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Permalink: More options, more losses
Tags: Swinging  for  the  Fences:  the  effects  of  CEO  stock  options  on  company  risktaking  and  performance  W.  G 

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