Risk-Taking Incentives and Returns on R&D Investment

Abstract

Traditional finance theory suggests that riskier investments should yield higher returns. Challenging this notion, anecdotal and empirical evidence suggests that highly-incented managers may take on excessive risk, leading to greater losses, while other theoretical research argues that high levels of option-based compensation may actually lead to greater risk aversion, resulting in lower return investment choices. Therefore, we assess whether incentives associated with stock option compensation (“vega”), presumed to increase managers’ appetite for risk, uniformly yield higher returns on R&D investment. Our results suggest that the return on R&D, as measured by future earnings and patent awards, varies concavely with vega. That is, low to moderate levels of vega correspond to increasing returns on R&D, consistent with vega inducing more profitable investments, but marginal returns decline as vega increases. Supplemental analyses suggest that these results are driven by greater risk aversion rather than excessive risk-taking. Overall, our results imply that risk-taking incentives (i.e., vega) may prove counterproductive.

Keywords: Executive Compensation, Managerial Incentives, Risk-Taking, Research and Development

JEL Classification: G31, G32, G34, G35, J33, M41, M52