Risk-taking in New Project Selection: Can Bonus Incentives Overcome Past Performance History?

Abstract

A challenge faced by many firms is how to encourage managers to undertake risk levels that are compatible with overall firm performance goals. Incentive compensation that is tied to financial returns is a common control mechanism that is meant to induce managers to strive for higher returns and/or to meet return targets. Prior research has found that under many circumstances incentives can affect behavior in terms of effort. We extend this research by examining whether incentive compensation affects risk taking in a new product selection context. Specifically, the purpose of this study is to investigate how past project performance history and bonus incentive pay schemes affect managers' propensity to select more or less risky projects. Performance history is manipulated via past positive outcomes (i.e. beating a target profit rate) and negative outcomes (i.e. missing a target profit rate). Two types of incentive pay schemes (hurdle bonus and graduated bonus) were employed in the study. The findings are consistent with prospect theory that predicts that prior bad outcomes (negative performance history) motivate greater risk-taking than prior good outcomes (positive performance history). However, contrary to expectations, we find no significant difference between hurdle and graduated bonus incentive schemes in the participants' willingness to take on riskier projects. Overall, external financial incentives were not able to overcome predicted experience effects that affect subjects' internal valuation of alternative projects. The study highlights the importance of past experience in predicting future risk taking behavior and the difficulty of overcoming these experience effects.

Keywords: Risk-taking, Performance History, Pay Schemes, Prospect Theory

JEL Classification: J33, G31, C91, M40, M46