LOSS AVERSION AND MANAGERIAL DECISIONS: EVIDENCE FROM MAJOR LEAGUE BASEBALL

I. INTRODUCTION AND MOTIVATION Previous research indicates that management changes are important events for organizations, partly because they lead to reversals of poor prior decisions, (1) However, this research begs the question of why it may be necessary to replace the manager in order to bring about such changes. In this article, we test for evidence of loss aversion and distinguish between loss aversion and agency costs as explanations for why managers "hang on" to poorly performing assets or employees they were instrumental in acquiring or hiring. The study contributes to the literature on managerial decisions and to the sports economics literature. It may be necessary to replace managers if their investment decisions are affected by loss aversion. As Aronson, Wilson, and Akert (2010) point out, avoiding admission of mistakes is a common human trait. Once we have committed time or energy to a cause, it seems to be nearly impossible to convince us that the cause is unworthy. Psychological aversion to admitting mistakes is related to loss aversion and reflects a cognitive bias. The manager fails to see the problem or discounts negative experience as non-representative. Agency costs provide an alternative explanation for why it may be necessary to replace managers to rectify prior mistakes. Agency costs arise when an agent (e.g., a manager) acts in his/her own interest but not in the interest of the principal (e.g., the firm owner). In the presence of asymmetric information, managers may have incentives to disguise or conceal poor decisions to avoid negative consequences such as reduced marketability as a manager, demotion, or termination. This concern with career and reputation can lead to overlooking inefficiencies, including asset underperformance and overpayment for the underperforming assets. Using three decades of data on managerial and player turnover in Major League Baseball (MLB), we: (1) estimate the tendency of incumbent managers to hold on to low-performing players rather than divest them; (2)test the hypothesis that new managers unwind the mistakes of previous managers; and (3) distinguish between loss aversion and agency costs as alternative explanations for retention of poor-performing players. Our empirical analysis focuses on poor-performing players who were hired by previous managers. This is because either loss aversion or agency cost may have induced the prior manager to hang onto poor-performing players. New managers can be expected to move quickly to address these types of problems; hence, we can use new manager retention decisions to determine if the decisions are affected by whether or not the poor performer was hired by a previous manager. Failure of the acquiring manager to divest poor-performing players could be consistent with either the manager's aversion to loss (a cognitive bias) or the manager's unwillingness to admit mistakes (agency costs in the form of career concerns). To distinguish between these, we follow the career concerns literature and reason that experienced managers are less likely to suffer reputational harm if they terminate poor performers whom they hired. Loss aversion, in contrast, does not suggest a relationship between managerial experience and failure to terminate poor performers. There are several advantages to using baseball data for this study. The empirical design holds industry and competitive conditions constant and allows us to directly observe the performance of acquired assets (players) and how managers react to their performance once it is revealed. We are able to identify the manager who made the acquisition decision and can measure the performance of individual players. We also observe the player retention decisions of the subsequent manager (the manager who did not acquire the player). Hence, we can evaluate how the acquiring manager's behavior differs from that of the manager who inherits poor-performing players, some who were acquired by the prior manager and others who were hired by even earlier managers. …