Maximizing the Wealth of Fictional Shareholders: Which Fiction Should Directors Embrace?

Abstract

Corporate directors are generally committed to the social norm of maximizing the wealth of their corporation's common shareholders. Their current practice is to simplify their investment decisions by positing a generic fictional shareholder who is undiversified in his investments as the person to whom they hold themselves accountable. In this Article I discuss this fictional undiversified shareholder concept and compare it with three alternative fictional characterizations that differ from it and among themselves only in the extent of assumed investor diversification, and which could each serve this same analytical function. These three alternatives are the fictional diversified shareholder, the fictional equity-only diversified shareholder, and the fictional corporation-specific diversified shareholder concepts. I also consider a hybrid characterization that would include both fictional undiversified shareholders and fictional diversified shareholders.

My conclusion is that despite its advantages of greatly simplifying directors' decision making we should discard the fictional undiversified shareholder concept for two reasons. First, it is highly unrealistic, more so than the other alternatives here considered. Second, it is indeterminate as to the degree of risk-aversion that should be ascribed to this fictional shareholder, and this degree of freedom completely undercuts ability of the shareholder wealth maximization norm to constrain director conduct.

I also conclude that if corporation investment decisions are best pursued through the use of a fictional shareholder concept, rather than through attempts by directors to ascertain and satisfy to the extent possible the conflicting preferences of their corporation's actual shareholders and perhaps other stakeholders as well -- a question discussed but not resolved in this Article -- then the fictional diversified shareholder concept, despite its significant implementation difficulties, is the preferred alternative among those here considered.

JEL Classification: K22