A Market Truism Turned On Its Head

Conventional wisdom in the markets says that risk equals reward. The riskier an investment is, the higher the reward an investor expects. Could the inverse be true, at least when it comes to executive compensation?

A recent study by economists at the University of Wisconsin and the University of Missouri found evidence that reducing C.E.O. pay -- or at least the portion of that pay in the form of stock options -- can result in less-risky corporate strategy, and improved profitability.

The study, "Earnings Restatements, Changes in C.E.O. Compensation, and Firm Performance," was written by Qiang Cheng, an associate professor of accounting and information systems at Wisconsin, and David B. Farber, an assistant professor of accountancy in Missouri's Robert J. Trulaske Sr. College of Business. It appears in the September issue of The Accounting Review.

"It's easy for the well-intended C.E.O. who has too many stock options to take risky investments," Farber said. "The research results strongly support that a decrease in option-based compensation reduces C.E.O.s' incentives to take excessively risky investments, resulting in improved profitability."

The researchers came to that conclusion by studying 289 companies that had restated earnings between 1997 and 2001.

Reckless risk-taking has become an urgent matter amid the varied securitization and lending crises currently buffeting the global economy. Earlier this week, John White, director of the Securities and Exchange Commission's corporate finance division, urged U.S. companies to limit compensation packages that reward excessive risk-taking by their executives.

"While stock options can be used to persuade mangers to take risky positive projects, high levels of options can induce excessive risk-taking in investment decisions," Farber said. "When these investments do not produce net positive returns, managers may engage in earnings management to mask underperformance. This can ultimately result in a restatement."

Or worse.

by Mark Stein