Aurora Borealis
2 August 2018 CFA Institute Journal Review

Board Diversity, Firm Risk, and Corporate Policies (Digest Summary)

  1. Butt Man-Kit, CFA

Greater diversity on boards of directors leads to lower risk and higher performance. These boards adopt more persistent and less risky policies and invest more in research and development compared with less diverse boards. Furthermore, the lower risk does not come at the expense of shareholder value. Instead, high board diversity increases profitability and firm value.

How Is This Research Useful to Practitioners?

Board diversity has gained more attention in recent years. Some countries now have a legal requirement to include a certain percentage of female directors on boards. Whether greater diversity is related to better performance is still controversial. Advocates believe that homogeneity among board members results in more unchecked decisions and riskier policies. The opposite side of the argument is that greater diversity may provoke conflicts and disrupt the decision-making process. The authors investigate the issue and find that greater board diversity is associated with lower firm risk and better financial performance.

First, the authors observe that a one-standard-deviation increase in board diversity leads to a 0.8% decrease in stock return volatility. The authors further investigate which diversity components—gender, age, ethnicity, education, financial expertise, and other board experience—matter more for reducing firm risk. Surprisingly, no single diversity component seems to explain the relationship; it is the combination that affects firm risk.

In addition, the effect of board diversity on stock return volatility becomes stronger when the firm has higher R&D investment intensity or asset market-to-book ratio. This result suggests that a more diverse board can check erratic decisions when the firm has higher fundamental risk. Board diversity becomes less effective in times of higher market uncertainties, which suggests that making quick decisions is more important than weighting different views in highly volatile periods.

Firms with greater board diversity also have more-persistent corporate policies, lower leverage, higher dividend payments, and higher R&D intensity. In particular, the effect on innovation efficiency is impressive: A one-standard-deviation increase in board diversity is associated with an increase of 2.8 standard deviations in number of patents. Greater board diversity also leads to higher profitability and greater firm valuation.

How Did the Authors Conduct This Research?

The authors’ sample includes all nonfinancial, nonutility firms in the United States from 1996 to 2014. They compute the diversity index with data from RiskMetrics and ExecuComp. Dependent variable data and control variables are mainly from the Compustat and CRSP databases. Patent data are extracted from the NBER patent database. The final sample consists of 21,572 firm-year observations.

To measure board diversity, the authors measure the six diversity components listed in the previous section. In their diversity index, all six components are weighted equally.

As in any causal relationship analysis, endogeneity is an issue. To determine the causality direction—whether greater board diversity reduces firm risk or the other way around—the authors adopt instrumental variable (IV) tests. They let the “intensity of non-stop flights to the headquarters from other cities in the US” serve as the IV for measuring board diversity and conjecture that a higher intensity of non-stop flights leads to higher board diversity. The logic is that non-stop flight schedules reduce the traveling costs for potential directors who live far away from the company headquarters, which in turn leads to a larger supply of nonlocal potential directors and improved board diversity. The idea is logically and empirically valid. The authors then conduct two-stage least-squares regressions to explore the relationships among board diversity, firm risk, corporate policies, and financial performance.

Abstractor’s Viewpoint

Doing good by doing well is possible. Traditionally, some people believe that promoting board diversity is just a sign of corporate social responsibility and has no real positive effect other than brand building. However, more and more evidence is being found to prove that a diverse board helps to improve corporate governance.

Beyond the six characteristics measured by the authors, it is plausible that diversity in values, life experiences, culture, socioeconomic status, and religion may also add value to the positive effects of board diversity. Because a firm necessarily works with and for people, if the board itself forms a miniature of the society at large, then it should able to better address the needs of the labor and consumers and avoid some taboos in doing business. Especially for international firms, having a globally diverse board may help to explore external opportunities, discover innovative business ideas, and enhance awareness of culturally sensitive issues.


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