Over the last few years, politicians and the media have increasingly argued that CEOs are paid too much and that current executive compensation practices push employees to take short-term risks with little regard for the long-term effect on their companies. Consequently, recent regulatory proposals have called for significant proportions of pay being offered through options, restricted equity, or other forms of long-term compensation designed not to reward short-term performance.1
These proposals follow the recommendations of the academic literature on agency theory and executive compensation which has argued for the past three decades that CEO compensation should be aligned to firm performance (see for example, Holmström, 1979, Grossman and Hart, 1983, and Jensen and Murphy, 1990). To the extent that long-term compensation plans offer incentives to CEOs to act in the best interest of shareholders going forward, and to the extent that markets do not fully incorporate pay information when it is made public, these proposals would seem to imply a positive relation between incentive pay and future returns. However, the evidence on whether compensation is related to future firm performance is decidedly mixed. For example, Abowd (1990), Lewellen, Loderer, Martin, and Blum (1992), and Tai (2004) find a positive relation between pay and future stock returns. Other papers document an equally strong negative relation between executive pay and future returns (see for example, Core, Holthausen, and Larcker, 1999, or Brick, Palmon, and Wald, 2006). The former set of papers attributes the positive relation between executive compensation and future performance to incentive alignment between the shareholders and the executives, while the latter set of papers attributes the negative relation between compensation and firm performance to agency issues. Both sets of papers typically assume that managers are rational economic actors who understand the incentives provided by the board and act accordingly, either to maximize shareholder value or their own private benefits. During the past decade however, an increasing number of papers have argued that managers are prone to behavioral biases that have real effects on firm actions and performance. One particular behavioral bias is overconfidence


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