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 manipulat e the market's inferences about the firm. The result can be overinvest ment or underinvestment. Shareholders can induce optimal investment ch oices by structuring managerial compensation to balance both future an d present stock-price performance. Our analysis suggests that firms wi th high/persistent informational asymmetries between managers and shar eholders will tend to favor contracts that focus on long-run stock ret urns (both current and future) over contracts that focus on near-term stock returns alone. Our empirical results, as well as other results i n the literature, are generally consistent with this hypothesis.