Rankings and Risk‐Taking in the Finance Industry

• Published date: 01 October 2018
• DOI: http://doi.org/10.1111/jofi.12701
• Author: MICHAEL KIRCHLER,UTZ WEITZEL,FLORIAN LINDNER
• Date: 01 October 2018

THE JOURNAL OF FINANCE •VOL. LXXIII, NO. 5 •OCTOBER 2018

Rankings and Risk-Taking in the Finance

Industry

MICHAEL KIRCHLER, FLORIAN LINDNER, and UTZ WEITZEL∗

ABSTRACT

Rankings are omnipresent in the finance industry, yet the literature is silent on how

they impact financial professionals’ behavior. Using lab-in-the-field experiments with

657 professionals and lab experiments with 432 students, we investigate how rank

incentives affect investment decisions. We find that both rank and tournament incen-

tives increase risk-taking among underperforming professionals, while only tourna-

ment incentives affect students. This rank effect is robust to the experimental frame

(investment frame vs. abstract frame), to payoff consequences (own return vs. family

return), to social identity priming (private identity vs. professional identity), and to

professionals’ gender (no gender differences among professionals).

IN RECENT YEARS,EXCESSIVE RISK-TAKING in the finance industry has been de-

picted as one of the main factors contributing to the global financial crisis

∗All authors contributed equally. Michael Kirchler is in the Department of Banking and Fi-

nance, University of Innsbruck, and Department of Economics, Centre for Finance, University of

Gothenburg. Florian Lindner is at Max Planck Institute for Research on Collective Goods, Bonn.

Utz Weitzel is at the Utrecht University School of Economics, and Institute for Management Re-

search, Radboud University. We are grateful to the Editor, Bruno Biais, one Associate Editor,and

two anonymous referees for excellent and constructive comments during the editorial process.

We thank Loukas Balafoutas; Gary Charness; Alain Cohn; Oege Dijk; Florian Englmaier; Sascha

F¨

ullbrunn; Cary Frydman; Maximilian Germann; Fabian Herweg; J¨

urgen Huber; Michel Andre

Marechal; Peter Martinsson; Kurt Matzler; Stefan Palan; David Porter; Jianying Qiu; Stephanie

Rosenkranz; David Schindler; Simeon Schudy; Joep Sonnemans; Matthias Stefan; Rudi Stracke;

Matthias Sutter; Alexander Wagner; Janette Walde;Erik Wengstr¨

om; Stefan Zeisberger; seminar

participants at the Universities of Bergen, Innsbruck, Lund, Munich, Nijmegen, London, Salzburg,

Trento, Trier, and Utrecht; as well as conference participants at the AEA Annual Meeting 2017 in

Chicago, H˚

allbara Finanser in Stockholm 2017, Status and Social Image Workshop (WZB) 2017

in Berlin, Experimental Finance 2017 in Nizza, Research in Behavioral Finance Conference 2016

in Amsterdam, Behavioral Economics of Financial Markets Workshop in Zurich 2016, EFA2016 in

Oslo, ESA 2016 in Bergen, ESA 2015 in Heidelberg, Experiment a BIT 2015 in Trento, Experimen-

tal Finance 2015 in Nijmegen, and eeecon Workshop 2015 in Innsbruck for valuable comments. We

are grateful to Enrico Calabresi, Michael D¨

unser, Achiel Fenneman, Felix Holzmeister, Dirk-Jan

Janssen, Patricia Leitner, Fritz P¨

ollmann, Melanie Prossliner, Lorenz Titzler, Alexander Wolf, and

Jan Zatocil for excellent research assistance. We particularly thank Rani Piputri and all partici-

pating financial institutions and professionals for valuable collaboration. Financial support from

the Austrian Science Fund (FWF START-grant Y617-G11 and SFB F63), Radboud University,

and the Swedish Research Council (grant 2015-01713) is gratefully acknowledged. This study was

ethically approved by the IRB (Internal Review Board) of the University of Innsbruck. All three

authors declare that they have no additional relevant or material financial interests that relate to

the research described in this paper.

DOI: 10.1111/jofi.12701

2271

2272 The Journal of Finance R

(Financial Crisis Inquiry Commission (2011), Dewatripont and Freixas (2012)).

In particular, bonus schemes and tournament incentives have been identified

as among the main drivers of excessive risk-taking in developed financial mar-

kets (Rajan (2006), Diamond and Rajan (2009), Bebchuk and Spamann (2010)).

Tournament incentives are characterized by two major components. The first

and more obvious component comprises salary and other material rewards

that depend on performance, which create rank-dependent “monetary incen-

tives” to outperform others. The second and less obvious component comprises

“nonmonetary incentives” to outperform peers. This second component—called

“rank incentives”—provides utility to those at the top of the ranking and disu-

tility to those at the bottom (Barankay (2015)) and thus captures relative per-

formance preferences.1These nonmonetary, relative performance preferences

can be driven by the desire for a positive self-image (B´

enabou and Tirole (2006),

K¨

oszegi (2006)), or by concerns about public status (Frank (1985), Moldovanu,

Sela, and Shi (2007)). Hence, rank incentives play a prominent, explicit role in

tournaments. In the finance industry, rankings, ratings, and awards are the

visible hallmarks of a strong culture of relative performance measurement and

social competition. Funds are ranked or rated annually as are their managers.2

Awards to the “Fund Manager of the Year,” “Banker of the Year,” or “Analyst of

the Year” are sought-after distinctions in many areas of finance.3More infor-

mally, financial professionals (henceforth, professionals) often compare them-

selves with others in discussions about their investments and successes (“cheap

talk”; see Crawford (1998)), effectively ranking each other on an ongoing basis.

Recent evidence from laboratory and field experiments shows that, on aver-

age, rank incentives increase individuals’ effort and performance (Azmat and

Iriberri (2010), Blanes-i-Vidal and Nossol (2011), Tran and Zeckhauser (2012),

Bandiera, Barankay, and Rasul (2013), Delfgaauw et al. (2013)), but they also

promote unethical behavior (Charness, Masclet, and Villeval (2014)). In an

industry where competition and relative performance evaluation take center

stage, it is striking that no evidence exists showing how competition for rank af-

fects professionals’ behavior. In this study, we narrow this gap by investigating

the impact of rankings on professionals’ risk-taking in investment decisions. To

do so, we conducted lab-in-the-field experiments and online experiments with

657 financial professionals from major financial institutions in various OECD

countries as well as laboratory experiments with 432 students. Importantly,

we only recruited professionals who regularly engage in investment decisions.

The experiments differ in the selection of participants (professionals vs. stu-

dents), in the frame in which the investment decisions were made (investment

frame vs. abstract lottery frame), in payoff consequences (own return vs. family

1See Veblen(1899)andFestinger(1954) for classical papers and Roussanov (2010) for a finance

application.

2See, for example, http://www.morningstar.com/,http://money.usnews.com/funds/mutual-funds,

and http://www.bloomberg .com/ news/articles /2014- 01-08 /glenview- s-robbins -tops- hedge-fund -

ranking-with-bet-on-obamacare.

3See, for example, http://www.fmya.com/,http://www.investmentawards.com,andhttp://excell

ence.thomsonreuters.com/award/starmine.

Rankings and Risk-Taking in the Finance Industry 2273

return), in professionals’ social identity (private identity vs. professional iden-

tity), and whether the ranking was payoff-relevant (nonincentivized ranking

vs. tournament incentives). Such variation allows us to draw a comprehensive

picture of the role of rankings in professionals’ risk-taking behavior.

In the first experiment, PROF, we investigate the extent to which nonincen-

tivized rankings and tournament incentives drive professionals’ risk-taking in

framed investment decisions. Specifically, we recruited 252 professionals and

administered repeated portfolio choices between a risk-free asset and a risky

asset over eight periods. In the baseline treatment, professionals faced lin-

ear incentives and were paid according to their final wealth. In the ranking

treatment, the setup was identical except that participants also received feed-

back on their anonymous ranking among their peers. The ranking itself was

not payoff-relevant. We find that, compared to the baseline, underperformers

take significantly more risk when an anonymous and nonincentivized ranking

is displayed. We also administered a tournament treatment that was identi-

cal to the ranking treatment except that the ranking was relevant for pay-

out. In line with the literature on bonuses and risk-taking (e.g., Rajan (2006),

Kleinlercher, Huber, and Kirchler (2014)), we find that the average risk-taking

of professionals increases with tournament incentives compared to the base-

line. This increase in risk-taking is driven mainly by underperformers. When

focusing on rank-dependent risk-taking, the results suggest that rank incen-

tives shape risk-taking in the tournament treatment. In fact, monetary incen-

tives in the tournament treatment have little effect on the rank-dependent

risk-taking that we observe in the ranking treatment. This finding indicates

that simply displaying a nonincentivized ranking activates professionals’ rela-

tive performance concerns, often at the tournament level.

If relative performance concerns are universal in framed investment deci-

sions, one might expect rank-driven behavior to be equally strong among pro-

fessionals and nonprofessionals. To test this prediction, we conduct a second

experiment, STUD, in which we examine whether the results above hold for a

sample of 432 students who obviously have no financial professional identity.

This experiment is identical to PROF in treatments and design except that

the stakes are lower. We find that, in contrast to the results for professionals,

in the ranking treatment students’ risk-taking is not driven by rank incen-

tives. In the tournament treatment, however, incentivized rankings increase

risk-taking among underperformers, in line with our findings for professionals.

These findings raise questions about the source of behavioral differences

between industry professionals and nonprofessionals. One possible explana-

tion for such differences is that professionals import their professional identity

and industry experience into the laboratory. According to the social identity

theory of Akerlof and Kranton (2000), decision makers have multiple social

identities (based on, e.g., gender, ethnicity, or occupation) that prescribe how

they should behave when a certain identity is salient. Behavior is influenced

because individuals experience disutility if their behavior deviates from what

their identities specify.Cooper et al. (1999), for example, show that the behavior

of Chinese managers depends on whether the framing of the task relates to the