STOCK-BASED INCENTIVE COMPENSATION AND INVESTMENT BEHAVIOR

This paper examines how excessive concern over current stock price can motivate managers to use observable investment decisions to manipulate the market's inferences about the firm. The result can be overinvestment or underinvestment. Shareholders can induce optimal investment choices by structuring managerial compensation to balance both future and present stock-price performance. Our analysis suggests that firms with high/persistent informational asymmetries between managers and shareholders will tend to favor contracts that focus on long-run stock returns (both current and future) over contracts that focus on near-term stock returns alone. Our empirical results, as well as other results in the literature, are generally consistent with this hypothesis.