Bad bets: Nonlinear incentives, risk, and performance

Abstract

Research Summary This article examines the consequences of incentive slope and shape on performance and risk‐taking. It focuses on how slope—incentive intensity—influences risk‐taking, and how shape—nonlinearity—influences performance. We use quasi‐random variation in the context of the hedge‐fund industry to separate slope and shape effects. Our results demonstrate that shape has large and important effects on performance, and that slope affects risk‐taking. The evidence suggests that poor performance in the industry is often due to bad bets—excessive risk‐taking that reduces performance—taken in response to nonlinear incentives. The findings suggest that, although nonlinear incentives are widely used, they can, under certain circumstances, predictably produce pernicious effects on organizational performance. Managerial Summary This article examines how nonlinear incentive contracts—such as contracts that reward performance above a threshold substantially more than below it—influence managerial behavior. Using the hedge‐fund industry, in which nonlinear incentives are ubiquitous, as a laboratory, we find that nonlinear incentive schemes cause managers who are “close” to, but below, the performance threshold to take bad bets—excessive risk‐taking that reduces performance. The findings suggest that, although nonlinear incentives are widely used, they can, under certain circumstances, predictably produce pernicious effects on organizational performance.

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“…Among hedge funds that diversify their product portfolios, most actively seek opportunities to generate synergies across funds by sharing some aspect of research, sales, compliance, trading, and other resources and activities. Moreover, as a practical matter, once a firm manages to open a fund, it will only close the fund if it performs quite poorly, since only funds with deeply negative returns have little chance of generating incentive fees (de Figueiredo, Rawley, & Shelef, ).…”

The “Sales Agent” Problem: Effort/Leisure Allocation Under Performance Pay as Behavior Towards Risk

“…Another alternative is to offer convex output‐based incentives, whereby the agent's pay grows faster than his/her output to compensate for the increasing costs of bearing multiplicative risk. However, such convex incentives may encourage excessive risk taking by less risk‐averse agents, in much the same way as they have done in the hedge fund industry (de Figueiredo, Rawley, and Shelef ). An alternative to globally convex incentives are locally convex ones, which encourage extra effort from the risk‐averse agents who would otherwise have chosen low effort while not giving extra incentive for risk taking to the harder‐working, less risk‐averse agents.…”

Negative externality on service level across priority classes: Evidence from a radiology workflow platform

“…Many papers have addressed compensation schemes and their effects on workers' behavior and productivity, for example, Kerr (1975), Cadsby et al (2007), Wowak and Hambrick (2010), de Figueiredo Jr et al (2019), Mitsuhashi and Nakamura (2022). The compensation schemes studied include wage earning (Lazear, 1981), bonus structure (Timmer & Szirmai, 2000), profit sharing (Kruse, 1993; Wowak et al, 2014), and performance pay.…”