Are stock options an effective tool for managing CEO risk-taking? What about an individual’s innermost attitudes towards risk?Professors Tuck Siong Chung from ESSEC Business School Asia-Pacific, Yenn-Ru Chen from National Chengchi University, and Chia-Hsien Lin and Angie Low from National Chung Cheng University and Nanyang Technological University respectively, examine how the intrinsic motivations of CEOs interact with executive stock options compensation and influence their actions.

For the Love of Money: The impact of stock options on CEO risk-taking behaviour by CoBS Editor Celine Sophie Lüdtke. Related research: When do stock options affect CEO risk-taking? The moderating role of CEO regulatory focus, Yenn-Ru Chen, Tuck Siong Chung, Chia-Hsien Lin and Angie Low, Journal of Business Finance and Accounting, (2023).

The O’Jays is an R&B/ soul band and one of the most important representatives of Philly Soul. During the course of their career, they recorded 29 studio albums and over 90 singles. One of their most notable singles, “For the Love of Money”, deals with different risky (and, in the song itself, immoral) actions people would be willing to undertake to satisfy their avarice. The song includes harsh generalisations and hyperboles about people’s motivations and laconically comments on money’s influence on their behaviour.

Although it’s a great song from 1973, why is it relevant in an academic context? The O’Jays imply that financial incentives can influence certain people to take more risks. However, they also acknowledge that this does not apply to everyone. Therefore, at least according to them, this would mean that certain people have a predisposition for behavioural change to take riskier actions.

Professor Chung et al. deal with this idea in a business context: They focus on how CEOs’ different intrinsic attitudes towards risk-taking may affect their responsiveness (or lack thereof) towards risk-taking incentives and, in particular, executive stock options.

Does money make the world go round?

Professor Tuck S. Chung and his fellow researchers look at how a CEO’s innermost motivations to achieve gains and avoid losses may affect the response to risk-taking incentives in the form of stock options. More specifically, they investigate the interaction of intrinsic CEO motivations to take risks with this external initiative and ultimately ask: Do risk-taking incentives in the form of executive stock options work? And if so, what are the conditions for them to work?

Indeed, stock options for CEOs are currently used to reduce the problem of CEOs potentially under investing and averting risks in fear of failure. At the same time, studies and research on the actual impact of stock options on CEO risk-taking behaviour have been so far theoretically and empirically inconclusive. 

CEO risk aversion vs stock options

Compensation for CEOs and executives helps align their interests with shareholders, as the compensation links personal wealth to the firm’s performance. Using stock options for CEOs should incentivize them to take more risks, since it makes them part owners and allows them to benefit from any increase in their firms’ stock value. However, even stock options as a motivation tool for CEOs are a double-edged sword: they could also magnify the exposure of risk-averse CEOs to the firms’ risk and decrease risk-taking initiatives.

For example, by greatly increasing the stakes placed on how well firms perform, risk-averse CEOs may pass up investments providing positive returns that more than compensate for the risks involved. While researchers have empirically examined CEO stock options in the past and have found a positive relationship to CEO risk-taking, research on this topic remains difficult. This is due to the various possible confounding factors, omitted variables in the prediction models used, or the unclear cause-and-effect relationships. Risky business – why some people take risks and others don’t.  

Risky business – why some people take risks and others don’t

Drawing on Higgin’s Regulatory Focus Theory (RFT), two motivational systems – promotion and prevention – regulate behaviour. Individuals who are promotion-focused are motivated by achieving gains and hardly think about losses. They engage in riskier acquisitions and investment strategies as well as tending to invest more in R&D.

Conversely, prevention-focused individuals aim to avoid making mistakes and mitigate losses. As a result, they tend to engage in conservative decision-making even when it implies giving up potential gains. Promotion and prevention focus can be seen as a continuous spectrum with two opposite ends, where individuals are either in extreme positions or in the middle. Individuals can simultaneously showcase high levels of both foci, of just one, or neither.

Prof. Chung and his fellow researchers thus examined – in the context of the RFT – the relative strength of an individual’s promotion focus compared to their prevention focus, i.e. promotion focus predominance as well as the CEO’s prevention and promotion foci independently of each other.

Putting risk into numbers

Together with a final sample of 5,903 firm-year observations corresponding to 697 firms, the four researchers downloaded the corresponding annual reports. Other data, most notably CEO compensation and age, accounting data, stock return and volatility, were taken from Execucomp, Compustat, and CRSP, respectively.

Chung and his colleagues also analysed the content of CEO letters to shareholders to determine their regulatory foci. As CEOs usually personally write these letters or review the content, the researchers used an analytics platform to categorise each sentence as either prevention- or promotion-focused. They then scaled the sentences to obtain results on the CEO’s position on the prevention-promotion focus scale.

“Money can change people sometimes”: Were the O’Jays right?

Professor Chung et al. found that the motivations for risk-taking (the RFT) interact with risk-taking incentives, i.e. the stock option compensation structure.

While extremely risk-averse (prevention-focused) and extremely risk-loving (promotion-focused) CEOs were not impacted by stock options, CEOs with more intermediate and malleable motives were clearly influenced, as shown by the positive relationship between firm risk and CEO stock options.

Is confidence the key to success ….?

While regulatory focus is a decisive factor in influencing CEO risk-taking behaviour, CEO characteristics such as confidence also contribute to this phenomenon. While regulatory foci describe an individual’s goal-oriented motivation, personalities showcase their beliefs and evaluations of themselves.

Chung et al. discovered that CEO traits such as overconfidence, hubris, and narcissism affect a firm’s risk. However, the influence of these traits is moderated by motivational processes as measured by the RFT.

In line with the previous findings, CEO confidence can be a factor in influencing moderately risk-averse or risk-loving CEOs. Non-overconfident CEOs with a moderate prevention focus can be influenced by stock options, as can highly confident CEOs with a moderate promotion focus. However, the positive effect of stock options is stronger in non-overconfident CEOs with a moderate promotion focus. This suggests that CEO overconfidence may counteract the risk-taking benefits of stock options.

… and is age really just a number?

According to the research findings, younger CEOs are more responsive to stock options compared to their older counterparts. The study also found that moderate regulatory focuses are motivated by stock options, while these incentives do not sway CEOs with extreme motivational processes.

In summary, stock options are most effective in encouraging CEOs who do not already have deeply ingrained risk-taking attitudes.

What boards can do

Prof. Chung et al. found that firms already award a relatively higher percentage of compensation in the form of stock options to CEOs with moderate promotion foci compared to those with extreme foci. While boards cannot directly measure the risk-taking attitudes of their CEOs, they use their interaction with their CEOs to identify their promotion/prevention foci.

All in all, the study demonstrates the critical role played by intrinsic motivations and risk attitudes in shaping CEO behaviour in conjunction with extrinsic incentives, such as CEO stock options.

As such, understanding when stock options can be an effective tool to incentivise CEOs to take risks can help boards design better compensation packages.

Useful links:

• Link up with Professor Tuck S. Chung on LinkedIn
• Gain further insight with Tuck’s research on the influence of CEO and CMO confidence on marketing budgets
• Read a related article: CEO and Executive Compensation: Where ESG doesn’t pay off
• Discover ESSEC Business School Asia-Pacific in Singapore
• Apply for the MSc Marketing Management & Digital programme in Singapore.

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