Effects of Executive Compensation Complexity on Investor Behavior in an Experimental Stock Market

Abstract

This study experimentally investigates whether shareholders correctly anticipate the incentive effects of increasingly complex compensation packages given to managers, and whether potential biases in individual shareholder beliefs carry over to price and volume effects in a stock market. In the experiment, a manager makes a decision about the stochastic dividend process generating the firm's fundamental value, and shareholders make estimations about fundamental value and trade shares in a stock market. The manager's action is either known or hidden and, nested in the hidden action condition, compensation is either simple or complex.

We hypothesize that hidden action gives rise to perceived behavioral uncertainty, and that this uncertainty has valuation relevance in that it affects both individual estimations of fundamental firm value and stock prices. Furthermore, we hypothesize that perceived behavioral uncertainty increases with the complexity of compensation, and that compensation complexity also affects trading volume.

We find supporting evidence for our conjectures. Both estimations and market prices are biased when the manager’s action is hidden, and biases are stronger when compensation is complex. We further find that trading volume decreases when compensation is complex, even though the heterogeneity of investors’ individual beliefs increases.

Keywords: Executive compensation, corporate governance, experimental stock market, behavioral uncertainty

JEL Classification: M41, G30, C90