Investment, Idiosyncratic Risk, and Ownership




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    • Panousi is with the Federal Reserve Board, and Papanikolaou is with the Kellogg School of Management. We thank the editors and two anonymous referees for insightful comments and suggestions. We are grateful to George-Marios Angeletos; Janice Eberly; Jiro Kondo; Harald Uhlig; Toni Whited; and seminar participants at the Federal Reserve Board, the Chicago Fed, the Kellogg School of Management, the London School of Economics, the University of South California, Michigan State University, and MIT for useful comments and discussions. We are grateful to Valerie Ramey for sharing her data. Dimitris Papanikolaou thanks the Zell Center for financial support. The views presented in this paper are solely those of the authors and do not necessarily represent those of the Board of Governors of the Federal Reserve System or its staff members.


High-powered incentives may induce higher managerial effort, but they also expose managers to idiosyncratic risk. If managers are risk averse, they might underinvest when firm-specific uncertainty increases, leading to suboptimal investment decisions from the perspective of well-diversified shareholders. We empirically document that, when idiosyncratic risk rises, firm investment falls, and more so when managers own a larger fraction of the firm. This negative effect of managerial risk aversion on investment is mitigated if executives are compensated with options rather than with shares or if institutional investors form a large part of the shareholder base.