Performance evaluation and herd behavior in a laboratory financial market

Abstract

We consider the effect of performance evaluation on the herd behavior of fund managers in a laboratory financial market. Subjects acting as fund managers receive imperfect private information concerning the fundamental value of a stock, which they then trade in sequence with a market maker. When prices are flexible, subjects regard their private information and herd less frequently than when the price is constant. When price is fixed, subjects evaluated by relative performance tend to "go with the flow" to reduce any price deviation from their peers, but when the price is flexible, herd behavior almost disappears under relative performance evaluation as the increasing trading costs squeeze the net profit of follow-up imitators. Overall, the likelihood of rational decisions under relative performance evaluation is higher than under absolute performance evaluation.