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We've all endured lectures on efficient markets in graduate school: Prices are always right; humans are rational computing algorithms; beating the market is futile; and so forth. Enter behavioral economics, the study of economics when economic agents -- also known as "people" -- are no longer assumed to be 100% rational.
At Empiritrage, LLC we focus on turning academic insights into investment performance and many of our best trading ideas are focused on areas of the market where behavioral bias unduly influences price behavior. Interestingly enough, evidence for inefficient markets extend beyond stock markets. One market where this is true is in the market for athletic talent in the National Football League (NFL). Richard Thaler and Cade Massey conduct a wonderful research experiment analyzing the efficiency of NFL draft markets. The title of their paper is "The Loser's Curse: Decision-Making & Market Efficiency in the National Football League Draft" and a copy of the paper can be found at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=697121.
The paper analyzes decision-making during the NFL draft, an event where economic incentives are significant and outcomes are measurable. The authors develop the concept of surplus value for a given draft pick and show that teams consistently over-value the highest draft picks, indicating behavioral biases. Specifically, the authors conduct the following exercise:
- Estimate the market value of draft picks utilizing player trades.
- Compare the benefit of a using high drafts pick to the opportunity cost of trading for additional, lower picks.
- Calculate a surplus value equal to the draftee's performance value (regression of key performance statistics for veterans to veteran compensation) minus the draftee's salary.
The figure below shows a player's performance value, compensation, and surplus value by draft pick. Although performance and compensation both decrease monotonically, compensation does so at a greater rate. Thus, picks near the beginning of the second round of the draft have a greater surplus value than the highly desired first pick.
Behavioral biases can lead to market inefficiencies, not only in stock markets, but also in athletic markets. One nitpick on this paper is that the analysis undervalues the new collective bargaining agreement (CBA) signed by the NFL in 2011, which actually makes top picks more valuable. For example, Andrew Luck and Robert Griffin III (2012, #1 and #2 picks, new CBA) are paid around $5 million a year, when both made the pro bowl last year. A market contract for such a player would be at least $10-12 million per year. In contrast, Sam Bradford (2010, #1 pick, old CBA) was paid more guaranteed money than anyone in NFL history, without playing an NFL game.
The evidence certainly suggests that top picks are overvalued, on average. However, there are a handful of top overall picks -- Elway, P. Manning, E. Manning, and Aikman -- who won a combined 8 championships. The value of a championship is hard to quantify, but my guess is that many NFL owners would mortgage the entire value of their team in order to win a championship. Similar to stock investing, on average, buying high-flying growth stocks is a terrible bet, but owners of Microsoft in the early 80's won the equivalent of the NFL championship. Try telling them that growth investing is a waste of time.
Wesley R. Gray, Ph.D. is a finance professor at Drexel University and the Executive Managing Member of Empiritrage, LLC, an SEC registered investment advisor. Wes is the co-author of Quantitative Value: A Practitioner's Guide to Automating Intelligent Investment and Eliminating Behavioral Errors. He has a BS from The Wharton School, University of Pennsylvania, and an MBA and a PhD in finance from the University of Chicago Booth School of Business.