How Relative Compensation Can Lead to Herding Behavior

34 Pages Posted: 15 Feb 2013 Last revised: 22 Dec 2013

An Chen

University of Ulm

Markus Pelger

Stanford University - Management Science & Engineering

Date Written: November 21, 2013

Abstract

In this paper we analyze performance-based remuneration for risk-averse managers in a Black Scholes-type model. We assume that the firm's performance is influenced by an industry and a firm-specific risk. A relative performance compensation which rewards a manager relative to the exogenous performance of the firms in his peer group, can filter out the industry-specific risk and lower the compensation costs to the firm. However, if all managers of the firms in the peer group receive an endogenous relative performance compensation, we show that the managers may herd in their investment decisions and choose an inferior investment despite the presence of a more profitable alternative. This herding behavior is driven by the managers' risk-aversion and the endogenous relative performance compensation.

Keywords: relative compensation, management compensation, herding, risk-aversion

JEL Classification: G35, G14, G23, D82

Suggested Citation

Chen, An and Pelger, Markus, How Relative Compensation Can Lead to Herding Behavior (November 21, 2013). Available at SSRN: https://ssrn.com/abstract=2217715 or http://dx.doi.org/10.2139/ssrn.2217715

An Chen

University of Ulm ( email )

Helmholtzstrasse 20
Ulm, D-89081
Germany

HOME PAGE: http://www.uni-ulm.de/mawi/ivw/team

Markus Pelger (Contact Author)

Stanford University - Management Science & Engineering ( email )

473 Via Ortega
Stanford, CA 94305-9025
United States

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