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Is This Risk Necessary?

"Arguing in my spare time," No. 26

by Arnold Kling

Nov. 1, 1998
May not be redistributed commercially without the author's permission.

Most of us are familiar with stories of secretaries at high-tech firms becoming millionaires, thanks to stock options. These stories are presented as heartwarming illustrations of the capitalist system at its best.

While I have nothing against secretaries getting rich, from the standpoint of economic efficiency it makes no sense to give them stock options. Nor does it make sense to give stock options to most employees.

It can be argued that stock options give employees an incentive to perform. However, an employee with stock options can "free ride." If my individual performance does not affect corporate profits very much, then I can slack off without adversely affecting the value of my stock options. The use of stock options does not mitigate the need for the firm to use other means to incent and monitor the employee's performance.

Stock options can provide long-term incentives for employees to remain with the firm. However, one would think that there are other forms of deferred compensation or seniority-based benefits that could achieve the same effect.

Rational employees would prefer cash compensation to stock options. With cash, an employeee can achieve a superior combination of risk and return.

One of the most powerful and poorly-appreciated theorems in modern finance is that there is no reward for taking unnecessary risk. Risk that is diversifiable is unnecessary. Stock options force people to take concentrated risks that are not necessary.

People used to believe (in fact, many still do) that when you diversify your stock porftolio you lower your risk but reduce your expected return. The portfolio separation theorem says that diversification does not reduce expected return.

According to the separation theorem, there is an efficient way to trade off risk and return. Using the expected returns, variances, and covariances of assets, one can find an efficient portfolio, often called the market portfolio. The best way to trade off risk and return is to choose different weights between the market portfolio and a risk-free asset. If you want low risk and low return, put most of your assets into the risk-free asset. If you want high risk and high return, put most of your assets into the market portfolio.

Because diversification is so valuable, one can imagine a role for the stock market even if no capital investment were necessary. I have a limited set of skills, I only have time to work on a limited set of projects, and I can only work for a limited set of companies. Other things equal, I would like to take the income that I earn from my skills, projects, and companies and invest it in other companies so as to diversify my risk.

Many small businesses are sold to larger businesses. Why would this occur? Why would a larger business be willing to pay the small business owner enough to cause the small business owner to sell? The reason probably has to do with diversification. By selling, the small business owner is able to diversify risk which otherwise would be concentrated in the small business.

Consider two secretaries, Seth and Sheila. Seth gets $30,000 in salary, plus stock options that, if he could sell them today in the market, would be worth $2,000. Sheila gets $32,000 in salary. Which secretary is better off?

Seth might argue that his $2000 in options could make him rich some day. However, Sheila could turn her additional $2000 in cash compensation into potential riches, also. She could use the money to buy lottery tickets, for example. Alternatively, she could buy stock options in Seth's company. Or, better yet, she could buy out-of-the-money call options on the S&P 500 index. If the market takes off, she will be rich. Moreover, the separation theorem says that she can achieve a higher expected return for a given risk by purchasing securities based on the market portfolio than by owning stock options on any single firm.

This analysis could be made more sophisticated by taking into account taxes. For example, Seth's income in stock options is deferred for tax purposes until the options are exercised.

However, my guess is that the popularity of stock options is not due to sophisticated analysis. Rather, it is due to the opposite. Some employees probably overvalue stock options relative to cash compensation, and firms probably under-cost stock options relative to cash compensation.

Top executives at firms are themselves over-leveraged in their own companies. Because shareholders want the incentives of key decision-makers to reflect shareholder interests, top executives often own stock, stock options, and other forms of compensation that are tied to the stock price of the company. Because they are over-leveraged in their own companies, top executives will tend to want to go short in options in their company. One way to do that is to give stock options to employees in lieu of cash. This is particularly true as long as accounting rules allow firms to under-cost stock options when they report earnings.

The portfolio separation theorem is difficult for first-year business school students to grasp. One would not expect many computer programmer or secretaries to realize that a leveraged bet on the S&P 500 is superior to stock options in the company at which they work. Thus, it would not be surprising to have employees overvalue stock options. Options may be the compensation equivalent of frequent flyer miles—a currency with enormous psychic value relative to its intrinsic value. Having said that, when I was at Freddie Mac, most prospective employees placed little value on stock options.

Offering stock options may create interesting selection biases. The prospective employees who value stock options most highly may be workers who are least likely to recognize that it is rational to "free ride." Therefore, one's eagerness for stock options may signal one's willingness to work hard without close monitoring. This may allow firms to select people who will work harder by offering stock options. But this is a fairly subtle and fragile hypothesis.

In previous essays, I have suggested that the problem of allocating talent is becoming increasingly important. Stock options are considered a cool, contemporary solution to the problem. However, the economic case for stock options is disturbingly weak. My guess is that once the stock market euphoria has passed, the euphoria over stock options as a compensation tool will pass, also.