The recent carnage on European and US stock markets has only highlighted the problems of linking managerial compensation to stock market performance. Many employees who were lured to join new firms with the promise of lucrative stock options now find themselves holding worthless paper—while the firms themselves are wondering what they can do to stop employees from leaving in search of greener pastures.

Stock options are seen as a way of linking managers’ compensation to investor returns. The better a manager performs, the more the stock price will rise and the more the options will be worth. But as many employees of dot-com companies would now attest, stock price movements are a crude measure of how well managers are doing.

Short-term share price movements are driven in large measure by the market as a whole or by the industry sector. A statistical analysis of total returns to shareholders (TRS) for almost 400 companies since 1962 suggests that, on average, over 40 percent of the returns during any one- or three-year period can be explained by market and sector movements. (These are the periods over which share price performance is usually measured for the purpose of evaluating managerial performance.) So...