How Relative Compensation Can Lead to Herding Behavior

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