How Risk Aversion Motivates Executives
Skip to content
Finance & Accounting Mar 8, 2017

How Risk Aversion Motivates Executives

Incentivizing leaders with too much stock promotes caution—and encourages underperformance.

A CEO's risk aversion encourages underperformance.

Michael Meier

Based on the research of

Todd A. Gormley

David A. Matsa

Why do executives leave money on the table when running their companies?

Senior executives are often criticized for failing to work hard enough to create value for shareholders. It takes far less effort to stay the course, after all, than to make painful-but-profitable choices like redistributing resources, enforcing pay cuts, or closing a plant and laying off dozens of workers.

But a recent line of research suggests that executives are also guided by something else: risk aversion.

David Matsa of the Kellogg School and Todd Gormley of Wharton argue that managers shun making the risky—but potentially rewarding—decisions that could maximize a firm’s value because they wish to protect their compensation packages or preserve the sheen of success that will land them their next job.

Companies would do well to keep these career concerns in mind when designing incentives to protect shareholders. In particular, stock ownership—commonly offered to executives to encourage strong performance—may in fact encourage executives to play it safe.

“Paying in equity can create a perverse incentive,” says Matsa, an associate professor of finance.

Acquiring “Cash Cows” To understand the case for risk aversion, consider what happens when firms suddenly find themselves exposed to potential litigation.

In one study, Matsa and Gormley investigated the behavior of over 2,200 companies, each of which learned that one of the chemicals used in their production process had been declared a carcinogen. Because their employees had already been exposed to the chemical, the discovery dramatically increased the likelihood that the firm would need to spend significant sums on legal fees, insurance premiums, and other payments. It also heightened the risk of bankruptcy, should the chemical turn out to be the next asbestos.

In the face of uncertainty, and of potentially crippling liabilities, what did the companies do?

“They started buying other firms,” says Matsa. Discovering that their workers had been exposed to a carcinogen was linked to a 6% increase in acquisitions. But critically, acquiring these companies didn’t actually create any value for shareholders. That’s because, rather than making more strategic purchases, the troubled firms overpaid for large and unrelated “cash cows”—firms whose healthy profits might offset any future payouts the company would have to make.

“We likened it to how tobacco firms diversified into food when the health risks of smoking became more pronounced legally,” says Matsa. (Consider, as the most famous example, Phillip Morris’ acquisition of Kraft Foods in 1988.) “The managers were looking for a way to reduce risk.”

Matsa and Gormley argued that that the managers pursued this strategy to reduce their personal exposure. Because their compensation was closely tied to the firm’s performance, their own finances would have been disproportionately hit by the firm’s collapse. And because a catastrophe would likely cost them their jobs, their careers also hung in jeopardy.

Avoiding a Takeover

Next, the researchers decided to investigate whether career concerns led executives to be risk averse in other situations as well. In another study, Matsa and Gormley took advantage of variations in merger laws across the United States to see whether managers behave differently when they are “protected” from the threat of a takeover.

Options motivate executives to increase the stock’s value above a certain strike price, which often requires taking smart risks.

“Takeovers are seen as a disciplining force that makes managers less likely to run firms in a suboptimal way,” Matsa explains.

How so? Consider a scenario in which a firm creates 100 dollars of value. If someone else, running the firm differently, could create 110 dollars, than the firm is at risk of being purchased by that other party, perhaps for 105 dollars. Because the takeover would probably involve replacing management, the mere threat of a takeover keeps managers working hard to make sure no one can run the firm more profitably.

But some states make it much harder to complete hostile takeovers, giving executives in these states more leeway to avoid taking risks. “It’s a situation where they can pursue their own interests more easily,” Matsa says.

Indeed, corporate financial data over a 30-year period ending in 2006 showed that firms led by managers in “protected” situations tended to hold more cash and demonstrate less volatile stock prices.

Moreover, just as seen in the previous study, these managers actively reduced risk by pursuing safe, diversification-focused acquisitions. Their firms undertook 27% more acquisitions compared with unprotected businesses—with two-thirds of these transactions diversifying the firms into new industries rather than building on existing strengths. Disproportionately, the firms targeted “cash cows.”

And their caution negatively impacted their companies’ value, investments, and growth. “These incremental acquisitions destroy shareholder value on average,” Matsa says.

Consistent with the idea that the protected managers are playing it safe—rather than simply taking it easy, or shirking distasteful duties—the firms that did the bulk of the acquiring tended to be at a higher risk of failing. These companies had lower cash flows, greater leverage, and increased risk of financial distress. Their managers tended to have larger ownership stakes in their companies—putting their personal finances in more risk—and to be under the age of 55, with a longer career still ahead of them.

An Intervention Option

For firms that want to encourage prudent risk-taking by executives, research suggests a way forward.

For one, rethink the use of equity for compensation. Granting executives equity is typically viewed as a means of motivating behavior that increases shareholder value, because it creates a personal stake for the manager. But it also creates greater incentive to play it safe, as more of executives’ financial wealth is now tied to the firm’s prospects. Who wants to take a gamble with most of their eggs in the same basket?

Matsa speculates that compensating with ownership may be especially likely to backfire in firms that already face high risk, such as those close to bankruptcy. Stock options, on the other hand, should reduce executives’ tendency to play it safe. Options motivate executives to increase the stock’s value above a certain strike price, which often requires taking smart risks. Indeed, in other research by Matsa and his colleagues, options helped to mitigate the risk-averse behavior of firms that had recently learned of their workers’ exposure to a carcinogen.

Featured Faculty

Alan E. Peterson Distinguished Professor of Finance; Professor of Finance

About the Writer
Kellogg Insight Editorial Team
About the Research
Gormley, Todd A., and David A. Matsa. 2011. “Growing Out of Trouble? Corporate Responses to Liability Risk.” The Review of Financial Studies. 24 (8): 2781–2821.

Gormley, Todd. A., and David A. Matsa. 2016. “Playing It Safe? Managerial Preferences, Risk, and Agency Conflicts.” Journal of Financial Economics, 122(3): 431-455.

Gormley, Todd A., David A. Matsa, and Todd T. Milbourn. “CEO Compensation and Corporate Risk: Evidence from a Natural Experiment.” 2013. Journal of Accounting and Economics, 56(2–3): 79–101.

Read the original

Most Popular This Week
  1. One Key to a Happy Marriage? A Joint Bank Account.
    Merging finances helps newlyweds align their financial goals and avoid scorekeeping.
    married couple standing at bank teller's window
  2. Take 5: Yikes! When Unintended Consequences Strike
    Good intentions don’t always mean good results. Here’s why humility, and a lot of monitoring, are so important when making big changes.
    People pass an e-cigarette billboard
  3. How Are Black–White Biracial People Perceived in Terms of Race?
    Understanding the answer—and why black and white Americans may percieve biracial people differently—is increasingly important in a multiracial society.
    How are biracial people perceived in terms of race
  4. Will AI Eventually Replace Doctors?
    Maybe not entirely. But the doctor–patient relationship is likely to change dramatically.
    doctors offices in small nodules
  5. Entrepreneurship Through Acquisition Is Still Entrepreneurship
    ETA is one of the fastest-growing paths to entrepreneurship. Here's how to think about it.
    An entrepreneur strides toward a business for sale.
  6. Take 5: Research-Backed Tips for Scheduling Your Day
    Kellogg faculty offer ideas for working smarter and not harder.
    A to-do list with easy and hard tasks
  7. How to Manage a Disengaged Employee—and Get Them Excited about Work Again
    Don’t give up on checked-out team members. Try these strategies instead.
    CEO cheering on team with pom-poms
  8. Which Form of Government Is Best?
    Democracies may not outlast dictatorships, but they adapt better.
    Is democracy the best form of government?
  9. What Went Wrong at AIG?
    Unpacking the insurance giant's collapse during the 2008 financial crisis.
    What went wrong during the AIG financial crisis?
  10. The Appeal of Handmade in an Era of Automation
    This excerpt from the book “The Power of Human" explains why we continue to equate human effort with value.
    person, robot, and elephant make still life drawing.
  11. 2 Factors Will Determine How Much AI Transforms Our Economy
    They’ll also dictate how workers stand to fare.
    robot waiter serves couple in restaurant
  12. When Do Open Borders Make Economic Sense?
    A new study provides a window into the logic behind various immigration policies.
    How immigration affects the economy depends on taxation and worker skills.
  13. Why Do Some People Succeed after Failing, While Others Continue to Flounder?
    A new study dispels some of the mystery behind success after failure.
    Scientists build a staircase from paper
  14. Sitting Near a High-Performer Can Make You Better at Your Job
    “Spillover” from certain coworkers can boost our productivity—or jeopardize our employment.
    The spillover effect in offices impacts workers in close physical proximity.
  15. How the Wormhole Decade (2000–2010) Changed the World
    Five implications no one can afford to ignore.
    The rise of the internet resulted in a global culture shift that changed the world.
  16. What’s at Stake in the Debt-Ceiling Standoff?
    Defaulting would be an unmitigated disaster, quickly felt by ordinary Americans.
    two groups of politicians negotiate while dangling upside down from the ceiling of a room
  17. What Happens to Worker Productivity after a Minimum Wage Increase?
    A pay raise boosts productivity for some—but the impact on the bottom line is more complicated.
    employees unload pallets from a truck using hand carts
  18. Immigrants to the U.S. Create More Jobs than They Take
    A new study finds that immigrants are far more likely to found companies—both large and small—than native-born Americans.
    Immigrant CEO welcomes new hires
  19. How Has Marketing Changed over the Past Half-Century?
    Phil Kotler’s groundbreaking textbook came out 55 years ago. Sixteen editions later, he and coauthor Alexander Chernev discuss how big data, social media, and purpose-driven branding are moving the field forward.
    people in 1967 and 2022 react to advertising
  20. 3 Traits of Successful Market-Creating Entrepreneurs
    Creating a market isn’t for the faint of heart. But a dose of humility can go a long way.
    man standing on hilltop overlooking city
More in Finance & Accounting