Idiosyncratic Risk and the Manager∗

We develop a model to characterize and quantify the distortionary effects of stock, option, and fixed compensation on a manager’s choice of investment. Using the model, we estimate CEO investment incentives for 18,766 firm-year observations. We find the average CEO’s compensation contract incentivizes overinvestment by 1.5 percentage points per year, with significant variation across firms and over time. Our index of manager incentives helps to predict investment rates, valuation ratios, and acquisition activity. The impact of a CEO’s incentives on firm policy is strongest among firms with weak shareholder monitoring