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Notes -
That’s not really a downside risk (i.e., a risk of negative payoff), that’s just a risk of getting zero payoff.
Yes, sure, fine, if you account for opportunity costs, then losing a CEO job might be net negative (depending on base salary, length of and compensation during a post-termination non-compete period, if any, etc.—and, of course, on the value of the next-best alternative to being CEO)
But there is still a principal-agent problem here. The shareholders want (or should want, under homo economicus assumptions*) the CEO to be an agent who only takes +EV actions, where the “V” in “EV” is “market cap”. The more diversified the CEO personally is, the less he will personally care about declines in the value of the company’s equity—sure, if he makes some decisions which go south, then his equity compensation from this job might only be good for toilet paper, but if he’s already amassed a generational fortune and socked it away in a well-diversified portfolio, then a bet which is zero or negative expected value for the shareholders might very well be positive expected utility for the CEO. It’s just like how you’re much more inclined to go for a YOLO all-in with a questionable hand in poker when playing with Monopoly money than when playing with real money.
*There are some interesting ways in which homo economicus incentives break down when the shareholders themselves are all massively diversified; in the extreme case (which may no longer be all that extreme, now that everyone and his mum has piled into market cap-weighted index funds), everyone has the exact same equity portfolio, so all shareholders of company A are also shareholders of all of its competitors (B, C, D …). In such a world, it no longer makes sense for company A’s CEO to prioritize increasing market cap by any means; if he increases A’s market cap at the expense of B’s, the shareholders are no better off! But that’s a story for another time.
Ironically, since not being allowed to diversify is a bad thing, you need to pay people extra money for them to be willing to take a job which doesn't let them diversify, which means that that would raise CEO salaries.
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