Optimism bias and incentive contracts in portfolio delegation

This paper incorporates the well-documented managerial optimism bias into a standard portfolio delegation problem to study its impact on investment strategies and the optimal incentive contract offered by the investor to the manager. It is shown that the optimistic manager trades a larger quantity of the risky asset and thus takes more risk than the rational manager. Managerial optimism bias can offset her risk aversion and increase the investor's wealth by reducing moral hazard between the investor and the manager. Furthermore, a pronounced optimism bias reduces the incentive component of the incentive contract, suggesting that an optimistic manager requires fewer incentives to align her decisions with the interests of the investor. (C) 2013 Elsevier B.V. All rights reserved.