The Influence of a CEO's Prior Performance on her Risk Taking: A Prospect Theory Perspective

Abstract

I investigate how a CEO's prior performance affects her managerial decision making. Controlling for CEO fixed effects and employing reference points, I find that CEOs choose less risky projects after making gains. This result suggests that following good performance, a CEO feels relaxed and prefers to work on safe projects, consistent with an "S"-shaped value function as in prospect theory. The negative relationship between risk and prior performance exists only among CEOs with lower proportions of stock-based compensation. The results suggest overall that CEOs are subject to behavioral biases and that such biases can be mitigated by taking appropriate measures.

Keywords: Behavioral finance, risk taking, prospect theory, reference point, CEO compensation

JEL Classification: G32, M52