A Simple Model of Managerial Incentives and Portfolio-Investment Decision

What is the optimal portfolio allocation when a manager is investing both for his firm and for himself? I address this question by solving a manager’s decision problem under a specific executive compensation structure. I study how flat wage and stock compensation affect the manager’s investment decision. I show that the allocation is the same regardless of whether the manager is prohibited from trading the public shares of his own firm. Results from calibration show that the manager invests less in firm-specific technology and more in the aggregate stock market as the risk of the firm’s project increases. More stock compensation discourages him from investing in the firm’s risky technology, but encourages more risk-taking in terms of personal investment. In addition, I prove that flat wage, effectively as a riskless bond, hedges risk and leads to more risk-taking behavior both in firm investment and personal investment.