Risk and Incentives

By Orie Shelef

Risk taking is central to economic growth, entrepreneurship, and innovation, yet poor risk taking can have drastic consequences. Much of the research on risk-taking incentives has focused on balancing risk-reward trade-offs, while classic research on incentives has focused on encouraging effort. However, real world incentives fight not only these forces, but also, bad bets. Many incentive structures actually encourage usually dominated risky projects – projects with more risk and less return than less risky projects. These are not only hypothetical. Extrapolating just the hedge fund industry in which my research is set, bad bets cost investors $20 billion a year and subject them to extra risk equal to another $12 billion.

Hedge fund managers have pay that is hockey-stick like in their returns. Poor performance costs managers small amounts of pay while good performance increases their pay by a lot. While the details of their pay are what allow us to tie bad bets to explicit incentives, the features that induce bad bets are common across the economy. Hedge fund compensation and CEO compensation are surprisingly similar, though the terminology is different. Stock options and other explicit compensation such as increasing commissions, or implicit rewards, such as those for exemplary performance, have similar features. Beyond executives, millions of employees have stock options, sales people routinely have convex commission schemes, and others have performance pay schemes that reward risk. However, complicating both research and policy, these same features that can induce bad bets also induce effort and valuable risk-taking by risk averse individuals.

In my work (the latest version of which is: de Figueiredo, Rawley, and Shelef, 2016), we distinguish bad bets from valuable risk-taking and effort. First, we leverage the institutional details of hedge funds to identify the casual link between explicit incentives and both risk-taking and performance outcomes. Looking at both allows us to clearly identify the importance of bad bets. Bad bets are most clearly seem when we examine managers whose explicit incentives for both risk and effort have declined. If this manager was putting in effort and/or taking good bets, we would observe both risk and performance declining. We do observe these managers taking less risk, but they perform better. Clear evidence of bad bets.

Yet, if the same incentive features induce both good bets and bad bets, how can we avoid incenting bad bets without giving up on effort and good bets?

From an incentive scheme design, recognizing that managers may take normally dominated bad bets because of incentive structures, two features can help. First, stop rewarding great outcomes that are unlikely to arise under sensible risk taking. These rewards provide little incentive for effort or sensible risks, but do encourage excessive risk taking. For example, the move toward non-stock bonus contracts can do this, if they are well designed. Second, find ways to expose managers to more of the downside of failure, like the move to replace options with restricted stock. From an organizational and institutional perspective, risk controls, including empowering someone who is compensated to manage risk could be a valuable check. The rise of the “chief risk officer” may serve this role, but only with the right authority and incentives. More generally, even in settings where the firm is risk tolerant, it is important to design jobs and incentives with consideration for not only the right trade-off between risk and reward, but an awareness of bad bets.

At the ISNIE 2015 conference, Orie Shelef won the Ronald H. Coase Dissertation Award for his PhD thesis, “Essays on Contracting: Explicit Managerial Contracts and Implicit Relational Influence Contracts.”