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 using stock-based compensation to incentivize 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, when informed trading capital is a scarce resource, competition for informed investors creates excessive short-termism that destroys shareholder value, while in equilibrium, price informativeness stays the same. 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