The Impact of the Lack of The Impact of the Lack of Diversification in Managerial Diversification in Managerial

Portfolios on Corporate Portfolios on Corporate Social ResponsibilitySocial Responsibility

Philip L. Cochran, Indiana UniversityPhilip L. Cochran, Indiana University

Melissa S. Baucus, University of Melissa S. Baucus, University of LouisvilleLouisville

Ann K. Buchholtz, University of Georgia Ann K. Buchholtz, University of Georgia

October 15, 2006

OverviewOverview

• Many of the decisions top managers make Many of the decisions top managers make that negatively impact stakeholders may that negatively impact stakeholders may stem from top managers’ equity position in stem from top managers’ equity position in the firm, i.e., their position as undiversified the firm, i.e., their position as undiversified owners. owners.

• Increasing use of equity compensation was Increasing use of equity compensation was viewed as a way to more closely align top viewed as a way to more closely align top managers’ interests with those of owners. managers’ interests with those of owners.

• A consequence of top managers receiving A consequence of top managers receiving significant equity compensation is that their significant equity compensation is that their personal portfoliospersonal portfolios have become highly have become highly undiversified. undiversified.

ImplicationsImplications

• This, leads to resource allocation decisions that negatively impact the firm’s stakeholders.

• Executives with significant but undiversified personal portfolios will perceive decisions that benefit the firm’s primary stakeholders (excluding shareholders) as too risky financially.

• This has serious implications for corporate social responsibility.

Principal-Agent ProblemPrincipal-Agent Problem

• The intersection of research and The intersection of research and managerial practice is often a more managerial practice is often a more efficient and effective set of organizational efficient and effective set of organizational outcomes. outcomes.

• The use of equity and stock options The use of equity and stock options offered the potential to ameliorate the offered the potential to ameliorate the principal-agent problem.principal-agent problem.

• The “solution” was a dramatic jump in The “solution” was a dramatic jump in managerial equity.managerial equity.

• And the dot-com bust? And the dot-com bust?

Unintended ConsequencesUnintended Consequences

• However, the unintended consequence of However, the unintended consequence of this approach has been the creation of this approach has been the creation of wealth portfolios in the hands of managers wealth portfolios in the hands of managers that are unable to be sufficiently diversified. that are unable to be sufficiently diversified.

• Managers Managers holding undiversified wealth undiversified wealth portfolios will tend to be more risk averse portfolios will tend to be more risk averse than a diversified owner. than a diversified owner.

• Decisions by non diversified managers may Decisions by non diversified managers may be counter to the interests of diversified be counter to the interests of diversified owners, owners,

• This is completely at odds with the precepts This is completely at odds with the precepts of agency theory.of agency theory.

Example - PollutionExample - Pollution

• Diversified shareholders tend to hold Diversified shareholders tend to hold “market portfolios.”“market portfolios.”

• Pollution by one firm may help the focal Pollution by one firm may help the focal firm firm – but may many other firms in society but may many other firms in society – for a net negative social impact.for a net negative social impact.

• A diversified stockholder will want the A diversified stockholder will want the focal firm to reduce pollutionfocal firm to reduce pollution

• An undiversified stockholder will want the An undiversified stockholder will want the opposite.opposite.

Stakeholder SalienceStakeholder Salience

• Mitchell, Agle & Wood (1997) discussed the Mitchell, Agle & Wood (1997) discussed the salience of stakeholders when designing an salience of stakeholders when designing an approach to stakeholder management.approach to stakeholder management.

• Undiversified managers will likely be more Undiversified managers will likely be more prone to responding to stakeholders they prone to responding to stakeholders they view as highly instrumental. view as highly instrumental.

• Resource allocations may be directed in a Resource allocations may be directed in a manner that differs from the wishes of the manner that differs from the wishes of the more diversified owners.more diversified owners.

• This may invite the potential for unforeseen This may invite the potential for unforeseen conflict between the firm and its conflict between the firm and its stakeholders.stakeholders.

QuestionsQuestions

• Does stock ownership affect a top manager’s Does stock ownership affect a top manager’s approach to stakeholder management?approach to stakeholder management?

• Does stock ownership affect trade-offs made Does stock ownership affect trade-offs made by managers among various stakeholders?by managers among various stakeholders?

• Do executives with high equity holdings make Do executives with high equity holdings make decisions that result in poor performance with decisions that result in poor performance with some primary stakeholder groups? some primary stakeholder groups?

• What implications might this have for What implications might this have for theories of CSR?theories of CSR?