Stock Market’s Rise May Be Producing Crop of Very Cautious CEOs, Study of Stock Options Suggests

In the conventional view, exec options are a one-way street to riches, motivating top managers to embark on risky (some say too risky) strategies to gain Croesus-like wealth. But as a new study in the April issue of the Academy of Management Journal demonstrates, options are mixed gambles that can induce great caution.

Thus, when a CEO is just beginning to accumulate options, the new study finds, he or she is likely to take large risks as “the possibility for growing options wealth weighs more heavily than any risk of losses.” But when those same options have accumulated value, through rises in the company stock price, “the CEO is likely to perceive fewer opportunities for further advancing this wealth, leading to preoccupation with preserving current [stock-option] wealth.”

Complicating matters further is the fact that executives commonly face circumstances in which both motives are in play, where executives hold in-the-money options at the same time that new option grants present opportunities for further wealth. The new research finds that prospective wealth continues to spur risk-taking, though in muted form, even in the presence of the caution induced by the value accretion of older options.

In explanation, the study’s authors, Geoffrey P, Martin of Melbourne Business School, Luis R. Gomez-Mejia of Texas A&M University, and Robert M. Wiseman of Michigan State University, point to executives’ characteristic optimism. In their words, individuals’ tendency to “overweigh low-probability events…is stronger for gains than losses. Said differently, the CEO is more likely to overestimate the probability of earning future gains, leading them to overweigh the prospective wealth associated with strategic risk-taking.”

Introducing further complications are two other factors — 1) the growing tendency of CEOs to hedge gains through financial instruments (called put options) that guarantee a minimum sale price of stocks covered by company option grants and 2) the increasing vulnerability of CEOs to dismissal.

Although sometimes criticized as bets against their own firms, executive investment hedging has now become fairly commonplace, and the new research finds it has oddly contradictory effects on risk-taking: it accentuates the drag of current wealth but intensifies the pull of prospective wealth. Puzzling though the former result may be, the latter is in accord with the professors’ expectation that “the pursuit of additional wealth is further encouraged once the downside risk to future wealth is ameliorated through hedging.”

Vulnerability too is a growing trend. As the study notes, “Given that approximately half of CEOs are replaced every five years and the often well-publicized nature of CEO replacement by the media, a perception of vulnerability to dismissal by CEOs is likely to be ubiquitous.” Equating vulnerability with three consecutive years of share-price decline plus three years of decline in return on assets, the professors find that it erodes the negative effect of current wealth while neither increasing or decreasing the pull of prospective wealth. “This implies,” they write, “that highly entrenched CEOs — who by definition are less vulnerable to dismissal — are more likely to be influenced by current wealth than prospective wealth, seeking fewer risky investment alternatives as a result.” Further compounding this effect, they add, is that “entrenched CEOs are likely to have spent longer periods in the employment of the firm and therefore are also more likely to have had the opportunity to accumulate wealth in their stock options.”

A major, even dominant, component of executive compensation since the 1950s, stock options were originally proposed as a way to encourage strategic risk-taking. The idea was that it would align the interests of typically risk-averse CEOs, whose wealth is largely bound up with a single firm, with those of typically risk-neutral shareholders, whose holdings are likely to be spread over many companies.

The study’s findings emerge from data collected over 14 years (1996-2009) from all publicly traded manufacturing firms in a large executive-compensation database, with option-trading data being analyzed for 9,143 CEO-years. Strategic risk-taking was determined through three factors — 1) companies’ annual spending on research and development; 2) their spending on property plant, and equipment; and 3) changes in the amount of their long-term debt.

For all CEOs, the professors calculated the current paper value of stock options (averaging $13.5 million) from the number of options held at each year’s end multiplied by the amount the options were in the money. They calculated prospective value (averaging $18 million) from four factors — the number of options CEOs held, their expiration date, the price of the underlying stock, and the average yearly rise in the Dow industrial index (6.8%) during the 14 years covered by the study. Hedging was gauged from the availability of put options covering companies in the sample and the volume of trading in these instruments.

Among the findings:

  • An increase of one standard deviation in CEOs’ prospective stock-option haul (say, from the sample’s mean of $18 million to $46 million) was associated with a 33% increase in strategic risk-taking.
  • In sharp contrast, an increase of one S.D. in CEOs’ current stock-option haul (say, from the sample’s mean of $13.5 million to $42.5 million) was associated with a 18% decrease in risk-taking.
  • An increase of one S.D. in both prospective and current stock-option wealth was associated with a 5% increase in risk-taking.
  • Being able to buy put options as a hedge boosted by 30% the positive effect of prospective stock-option value on CEO risk-taking.

In sum, when company-granted stock options are a major part of their compensation, CEOs are most likely to take strategic risks when they are relatively new to their position, are able to hedge their gains, and have shown promise without yet having gained the total confidence of their directors. In the words of Wiseman, “A little bit of vulnerability, a pinch of financial hedging, and ample promise of bigger gains ahead.”

He adds: “After starting out as a cause celebre on behalf of strong executive leadership, stock options have lately come under a cloud for supposedly encouraging executive recklessness. In fact, the reality is more complex than either of these views would suggest. Our study concludes with a plug for straight-out stock grants as a safer alternative than options; still, there is no reason options cannot continue to be a useful tool provided boards strike the right balance between current and prospective wealth, a balance that will vary, depending on appropriate level of risk, from industry to industry and even from company to company.

“In short, this is a matter requiring active and continuing board involvement. Whether that happens in most companies — or whether boards simply take their cues from what other firms are doing — is another matter.”

The study, “ Executive Stock Options as Mixed Gambles: Revisiting the Behavioral Agency Model,” is in the April issue of the The Academy of Management Journal. a peer-reviewed publication published every other month by the Academy, which, with more than 18,000 members in 110 countries. The Academy’s other publications are the The Academy of Management Review, The Academy of Management Perspectives, and Academy of Management Learning and Education



Chief Executive: @ChiefExecGrp Chief Executive magazine (published since 1977) is the definitive source that CEOs turn to for insight and ideas that help increase their effectiveness and grow their business. Chief Executive Group also produces e-newsletters and online content at and manages Chief Executive Network and other executive peer groups, as well as conferences and roundtables that enable top corporate officers to discuss key subjects and share their experiences within a community of peers. Chief Executive facilitates the annual “CEO of the Year,” a prestigious honor bestowed upon an outstanding corporate leader, nominated and selected by a group of peers, and is known throughout the U.S. and elsewhere for its annual ranking of Best & Worst States for Business. Visit for more information.