Relative Performance Evaluation and Peer-Performance Summarization Errors

35 Pages Posted: 27 Apr 2011

See all articles by Shane S. Dikolli

Shane S. Dikolli

Darden School of Business University of Virginia

Christian Hofmann

Ludwig Maximilian University of Munich (LMU) - Faculty of Business Administration (Munich School of Management)

Thomas Pfeiffer

University of Vienna - Accounting and Control

Date Written: March 31, 2011

Abstract

In tests of the relative performance evaluation (RPE) hypothesis, researchers rarely, if ever, aggregate peer performance in the same way as a firm’s board of directors. Framed as a standard errors-in-variables problem, a commonly-held view is that such aggregation errors induce an attenuation bias (i.e., toward zero) of the regression coefficient on systematic firm performance. This creates a bias towards support for the hypothesis that boards use RPE. In contrast, this study analytically demonstrates that aggregation differences generate more complicated summarization errors that significantly differ from a standard errors-in-variables problem. In particular, we find that aggregation differences create a bias against finding support for the RPE hypothesis (i.e., inducing a Type-II error). We also show that when the board does not use RPE, an empiricist will not find evidence for RPE (i.e., precluding a Type-I error). Using simulation methods, we demonstrate evidence of the sensitivity of empirical inferences to the bias. In particular, the simulation shows how an empiricist can conclude erroneously that boards (on average) do not apply RPE, simply by selecting more, fewer, or different peers than those chosen by a board.

Keywords: Relative Performance Evaluation, Peer Group, Aggregation, Incentive Compensation, Summarization Error

JEL Classification: J33, M41

Suggested Citation

Dikolli, Shane Sami and Hofmann, Christian and Pfeiffer, Thomas, Relative Performance Evaluation and Peer-Performance Summarization Errors (March 31, 2011). Available at SSRN: https://ssrn.com/abstract=1823903 or http://dx.doi.org/10.2139/ssrn.1823903

Shane Sami Dikolli (Contact Author)

Darden School of Business University of Virginia ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
4342431018 (Phone)

Christian Hofmann

Ludwig Maximilian University of Munich (LMU) - Faculty of Business Administration (Munich School of Management) ( email )

Kaulbachstr. 45
Munich, DE 80539
Germany

Thomas Pfeiffer

University of Vienna - Accounting and Control ( email )

Bruenner Strasse 72
Vienna 1210, Vienna
Austria
+43-1-4277-38002 (Phone)
+43-1-4277-38004 (Fax)

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