Managerial reputation and corporate investment decisions - Corporate Investments Special Issue

Financial Management (Financial Management Association), Summer, 1993 by David Hirshleifer

This essay does not focus on designing contracts to deal with reputational incentives. Generally, one would expect that compensation schemes could be designed to mitigate unfortunate reputational problems partially, but not perfectly (e.g., Hagerty, Ofer, and Siegel |17~). Reputation has its good side as well, since a major motivation for working hard is to maintain a good reputation. Gibbons and Murphy |16~ point out that a manager has a greater incentive to work harder when far from retirement because he will bear the reputational consequences of his effort for a longer time. Thus, compensation contracts should be more performance-sensitive for managers close to retirement. They provide evidence supporting this prediction.

II. A Taxonomy of Reputational Pressures

This section provides a taxonomy of the different kinds of reputational pressures that managers face. It also analyzes how these different kinds of pressures interact; these interactions show up repeatedly in the applications of Section III.

A. Distortions

There are three main ways in which managers can manipulate investment decisions to improve their reputations. First, managers can take actions that make the current or short-term news about project outcome appear more favorable -- visibility bias. Second, managers can try to accelerate the arrival of news that is likely to turn out good, and delay the arrival of news that is likely to turn out bad -- resolution preference. Third, managers can try to imitate the investment choices expected of good managers, and diverge from the choices expected of bad managers -- mimicry and avoidance. Let us consider each of these points in turn.(5)

1. Visibility Bias

Visibility bias is defined as improving what is immediately visible, at the expense of what is not immediately visible. When dressing for a formal dinner, we spend more time choosing our pants than our underwear. This makes what is visible look good. This can be profitable even if it occurs at the cost of what is not visible (fancy tie, cheap underwear). Cosmetic surgery and steroid muscle building are other examples. These improve appearances, at the expense of a less visible substance (future health). A similar point applies more mildly to high heels, cosmetics, and shoulder pads. And wearing fine suits and fashionable dresses conveys an impression of the wearer's wealth, while at the same time reducing it. These behaviors are all examples of visibility bias.

Visibility bias applies to investment decisions as well. Consider a project about which public news is about to appear, such as early sales figures on a new product. The manager has an incentive to improve appearances by increasing the favorability of more visible events, for example, by offering hidden discounts on the new product to boost initial sales. He will try to distort early news reports favorably, even if this leads to an equal decrease in the favorability of permanent performance. To see why, suppose that no one but the manager is aware of his ability to offer hidden discounts. Then he receives a benefit from improved reputation now. The ultimate reduction in his reputation later is to the correct level. Thus, he receives an early reputational benefit without paying any later reputational cost.