Strategic Investment: Do Executives Exploit the Market?

“Strategic Investment: Do Executives Exploit the Market?”
Radovan Vadovic, Till Gross, Carleton University, Ottawa, Canada

The past fifty years of experimental research have shown that markets do an excellent job at aggregating information and allocating resources to their most productive uses. Occasionally we do observe signs of mispricing or insider manipulation. It is crucial to understand when markets have underperformed so that we are better prepared to deal with consequences of financial turmoil, such as what followed the real-estate bubble of 2008. This research concentrates on an argument by Brandenburger & Polak (1996), who show that in the presence of mispricing, firms’ executives (who are paid in part according to the stock price) may be able to exploit the market by investing strategically. When the stock is overpriced, they may invest too much; and vice- versa when the stock is underpriced. This typically leads to real economic losses. The argument relies on two key ingredients: (i) the market prices have to misrepresent firms’ fundamentals and (ii) at least part of executive compensation has to derive from the stock price (e.g., stock options or stock grants). In the past decade we have witnessed both – a major financial bubble and an unprecedented growth in the share of stock-price-based incentives. We propose to conduct the first empirical test of this conjecture by applying the methods of laboratory experimentation. In addition, we explore a promising possibility of mitigating the threat of strategic investment by restricting the share of stock-price-based incentives in managerial compensation. This will have implications for economic design and regulation of executive contracts.