Risk Taking of Executives under Different Incentive Contracts: Experimental Evidence

Classic financial agency theory recommends compensation through stock options rather than shares to induce risk neutrality in otherwise risk averse agents. In an experiment, we find that subjects acting as executives do also take risks that are excessive from the perspective of shareholders if compensated through options. Compensation through restricted company stock reduces the uptake of excessive risks. Even under stock-ownership, however, experimental executives continue to take excessive risks—a result that cannot be accounted for by classic incentive theory. We develop a basic model in which such risk-taking behavior is explained based on a richer array of risk attitudes derived from Prospect Theory. We use the model to derive hypotheses on what may be driving excessive risk taking in the experiment. Testing those hypotheses, we find that most of them are indeed borne out by the data. We thus conclude that a prospect-theory-based model is more apt at explaining risk attitudes under different compensation regimes than traditional principal-agent models grounded in expected utility theory

Risk Taking of Executives under Different Incentive Contracts: Experimental Evidence

Classic financial agency theory recommends compensation through stock options rather than shares to induce risk neutrality in otherwise risk averse agents. In an experiment, we find that subjects acting as executives do also take risks that are excessive from the perspective of shareholders if compensated through options. Compensation through restricted company stock reduces the uptake of excessive risks. Even under stock-ownership, however, experimental executives continue to take excessive risks—a result that cannot be accounted for by classic incentive theory. We develop a basic model in which such risk-taking behavior is explained based on a richer array of risk attitudes derived from Prospect Theory. We use the model to derive hypotheses on what may be driving excessive risk taking in the experiment. Testing those hypotheses, we find that most of them are indeed borne out by the data. We thus conclude that a prospect-theory-based model is more apt at explaining risk attitudes under different compensation regimes than traditional principal-agent models grounded in expected utility theory.prospect theory; expected utility theory; risk attitude; executive compensation; reference dependence; experimental finance

Certainty preference, random choice, and loss aversion: a comment on "Violence and Risk Preference: Experimental Evidence from Afghanistan"

I revisit recent evidence uncovering a preference for certainty in violation of dominant normative and descriptive theories of decision making under risk. I explore two alternative explanations of the preference patterns found: i) systematic noise; and ii) reference dependence activated by salient outcomes. I develop choice lists that allow to disentangle these different explanations, and test them on rural subjects in southern India. The results reject explanations based on a preference for certainty in favor of explanations based on random choice. The estimates are further distorted by response mode effects, with loss aversion leading to an over-estimation of risk aversion

Responsibility Effects in Decision Making under Risk

We systematically explore decision situations in which a decision maker bears responsibility for somebody else's outcomes as well as for her own in situations of payoff equality. In the gain domain we confirm the intuition that being responsible for somebody else's payoffs increases risk aversion. This is however not attributable to a 'cautious shift' as often thought. Indeed, looking at risk attitudes in the loss domain, we find an increase in risk seeking under responsibility. This raises issues about the nature of various decision biases under risk, and to what extent changed behavior under responsibility may depend on a social norm of caution in situations of responsibility versus naive corrections from perceived biases. To further explore this issue, we designed a second experiment to explore risk-taking behavior for gain prospects offering very small or very large probabilities of winning. For large probabilities, we find increased risk aversion, thus confirming our earlier finding. For small probabilities however, we find an increase of risk seeking under conditions of responsibility. The latter finding thus discredits hypotheses of a social rule dictating caution under responsibility, and can be explained through flexible self-correction models predicting an accentuation of the fourfold pattern of risk attitudes predicted by prospect theory. An additional accountability mechanism does not change risk behavior, except for mixed prospects, in which it reduces loss aversion. This indicates that loss aversion is of a fundamentally different nature than probability weighting or utility curvature. Implications for debiasing are discussed

Responsibility Effects in Decision Making under Risk

We systematically explore decision situations in which a decision maker bears responsibility for somebody else's outcomes as well as for her own in situations of payoff equality. In the gain domain we confirm the intuition that being responsible for somebody else's payoffs increases risk aversion. This is however not attributable to a 'cautious shift' as often thought. Indeed, looking at risk attitudes in the loss domain, we find an increase in risk seeking under responsibility. This raises issues about the nature of various decision biases under risk, and to what extent changed behavior under responsibility may depend on a social norm of caution in situations of responsibility versus naive corrections from perceived biases. To further explore this issue, we designed a second experiment to explore risk-taking behavior for gain prospects offering very small or very large probabilities of winning. For large probabilities, we find increased risk aversion, thus confirming our earlier finding. For small probabilities however, we find an increase of risk seeking under conditions of responsibility. The latter finding thus discredits hypotheses of a social rule dictating caution under responsibility, and can be explained through flexible self-correction models predicting an accentuation of the fourfold pattern of risk attitudes predicted by prospect theory. An additional accountability mechanism does not change risk behavior, except for mixed prospects, in which it reduces loss aversion. This indicates that loss aversion is of a fundamentally different nature than probability weighting or utility curvature. Implications for debiasing are discussed.risk attitude; other-regarding preferences; prospect theory; agency; social norms

Incentive Effects on Risk Attitude in Small Probability Prospects

Most studies on the role of incentives on risk attitude report data obtained from within-subject experimental investigations. This may however raise an issue of sequentiality of effects as later choices may be influenced by earlier ones. This paper reports instead between-subject results on the effect of monetary stakes on risk attitudes for small probability prospects in a laboratory experiment. Under low stakes, we find the typical risk seeking behavior for small probabilities predicted by the prospect theory. But under high stakes, we provide some evidence that risk seeking behavior is dramatically reduced. This could suggest that utility is not consistently concave over the outcome space, but rather contains a convex section for very small amounts.risk attitude, incentives, decision, experiment

Growth, entrepreneurship, and risk-tolerance: a risk-income paradox

Recent papers have modeled the prevalence of risk-tolerance as shaped by growth, making testable predictions about the distribution of risk-tolerance across the globe. We test these predictions using a dataset containing a survey question capturing people’s risk-tolerance for representative samples from 78 countries. We find a negative between-country correlation between risk-tolerance and GDP per capita. Together with the positive within-country correlation between risk-tolerance and income, this results in a risk-income paradox. We further find a negative interaction effect of risk-tolerance and GDP on fertility. These findings provide support for endogenous-preference models of economic growth

Process Versus Outcome Accountability

Private- and public-sector managers face a recurring organizational-design dilemma: the relative emphasis to place on process-versus-outcome accountability in evaluating employee performance. This chapter reviews experimental-psychological research that emphasizes the benefits of process accountability and then notes blind spots in that literature, especially the insensitivity to the relational signals that accountability manipulations convey about how evaluators view the evaluated. The chapter also examines real-world ideologically-driven debates over accountability design in which partisans tend to favor no-excuses forms of outcome accountability for those deemed untrustworthy and uncertainty-buffering forms of process accountability for the trustworthy. Finally, an integrative framework is proposed that examines how managers can balance the inevitable tradeoffs between decision-making control enhanced under process accountability and innovation fostered under outcome accountability, and sheds light on how agent empowerment can compensate for the deficiencies of both systems

Meta-Analysis of Empirical Estimates of Loss-Aversion

Loss aversion is one of the most widely used concepts in behavioral economics. We conduct a large-scale, interdisciplinary meta-analysis, to systematically accumulate knowledge from numerous empirical estimates of the loss aversion coefficient reported from 1992 to 2017. We examine 607 empirical estimates of loss aversion from 150 articles in economics, psychology, neuroscience, and several other disciplines. Our analysis indicates that the mean loss aversion coefficient is 1.955 with a 95% probability that the true value falls in the interval [1.820, 2.105]. We record several observable characteristics of the study designs. Few characteristics are substantially correlated with differences in the mean estimates

Measuring risk preferences in rural Ethiopia

Risk aversion has generally been found to decrease in income. This may lead one to expect that people in poor countries will be more risk averse than inhabitants of rich countries. Recent comparative findings with stu- dents suggest the opposite, potentially giving rise to a risk-income paradox. Findings with students, however, may result from selection effects. We test whether a paradox indeed exists by measuring the risk preferences of over 500 household heads across several regions in the highlands of Ethiopia. We do so using certainty equivalents, which are well suited to the task due to their simplicity. We find high degrees of risk tolerance, consistent with the evidence obtained for students using the same tasks. In particular, the level of risk tolerance is higher than the one found for student samples in most Western and even middle income countries. We also find risk tolerance to increase in income proxies within our sample, thus completing the paradox