Relative Performance Evaluation and Risk Taking in Delegated Investment Decisions*

Abstract

Providing proper incentives to firm managers is increasingly important in the current competitive environment. Analytical research has suggested that evaluating a manager's performance relative to that of a peer group, in conjunction with standard‐based pay, can induce efficient risk‐sharing between firm owners and managers while maintaining the latter's incentives to exert effort. To date, direct empirical tests of this proposition have not been reported. This study uses a laboratory experiment to test the effect of relative performance evaluation on the risk‐aversion of delegated investment decisions. Project‐specific risk is operationalized using operating leverage, in part because the variability of a project's operating profits generally increases with this variable, and in part because many of the new manufacturing approaches held to be important to competitive advantage require significant capital investments and attendant increases in operating leverage. Across two levels of environmental uncertainty, subjects under a relative (as opposed to absolute) performance standard selected investments with significantly higher project‐specific risk. Also, as environmental uncertainty increased, subjects under an absolute standard significantly reduced the riskiness of their investments. In contrast, subjects shielded from environmental uncertainty by a relative standard chose investments of about equal riskiness under both low and high uncertainty conditions. If supported by future research, these findings would suggest that relative performance evaluation may reduce managers' reluctance to adopt risky capital investments, especially in firms operating in high‐risk economic or technological environments.

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