The Short-Termism Trap: Competition for Informed Investors Under Stock-Based CEO Compensation

Abstract

We show that stock-based CEO compensation can create a "race to the bottom" among firms that escalates short-termist pressure. More informative stock prices reduce the agency cost of incentivizing managers. Also, shortening a firm's project maturity improves stock price informativeness by attracting informed investors, who prefer to invest in short-term assets. However, since informed trading capital is a scarce resource, competition for informed investors does not increase an individual firm's price informativeness in equilibrium: it simply creates excessive short-termism that destroys shareholder value. More intense competition between firms sharpens incentives to shorten project maturity, deepening the "short-termism trap."

Keywords: informed trading, managerial compensation, short-termism, optimal contracting, race to the bottom, strategic complementarities

JEL Classification: G14, G32, G38