The NFL Draft and Financial Markets
“The NFL draft wrapped up a few days ago, so this week I thought I’d open the TCI blog vault and highlight one originally posted in May 2014 that still holds true. When gauging how a football player will do in the future, people are only able to make judgements based on how they performed in the past. The same is true for financial markets, but you have to remember that “past performance is not indicative of future results.” Whether it’s an NFL General Manager or an investor, they might get lucky and make the right selection at the right time, but it doesn’t mean that they are more likely to outperform in the future. The average NFL career is short, so players need to maximize their playing time and earnings; at TCI our focus is on long-term investments, so we can help you achieve financial freedom.”
Sam Swift, CFA, CFP®, AIF®
I saw an interesting article this week written by Neil Paine. The beauty is that it combines the mathematical concepts behind the Efficient Market Hypothesis (one of the things I nerd out about frequently) and the NFL Draft (the other thing I nerd out about frequently). It’s a fun read—and a fun site in general—so I wanted to comment on a few points as a unique way for us to revisit the Efficient Market Theory. Take an early paragraph, for example:
Like traders bidding for commodities and speculating on their relative worth, each pick a team makes is essentially a statement about how it expects a player’s career to turn out. Overvalue the commodity (i.e., draft a guy too early) and you end up with a bust; undervalue it and risk another team walking away with a prized prospect. Because of all of the effort and examination being poured into these predictions, the draft is a robust market that, in the aggregate, does a good job of sorting prospects from top to bottom. Yet despite so many people trying to “beat the market,” no single actor can do it consistently. Abnormal returns are likely due to luck, not skill. But that hasn’t stopped NFL executives from behaving with the confidence of traders.
This is exactly what we see in financial markets where abnormal returns likely due to luck are often mistaken for skill. The Efficient Market Hypothesis doesn’t say that you can’t outperform the aggregate, just that an overachieving outcome will very likely be due to random chance, not skill, so you shouldn’t waste time devoting resources to it.
The NFL’s draft market differs slightly from the financial markets [Eugene] Fama analyzed. There are legal opportunities for teams to gather inside knowledge through prospect workouts and interviews, which a buyer can’t do with stocks. But a large proportion of the information teams use to make their picks — tape of prospects’ college games, their college statistics, biometric data from the pre-draft combine — is available to every team.
In the financial markets, it’s impossible to know more than the market does in aggregate—all known information is priced in. Paine points out that the NFL draft has evolved to the same point (as evidenced by the six months devoted to coverage of players you hadn’t heard of before) where the only real opportunity to outwit the market is to have a piece of information no one else does. In the financial markets, you probably could beat the market consistently by holding non-public information; unfortunately, “inside trading” happens to be illegal so it’s probably not the best strategy.
If teams showed any consistency in their ability to out-draft the market, it would show up in these deviations. But, as Chase Stuart of FootballPerspective.com has also found, there’s practically no correlationbetween a team’s picking performance from one draft to the next.
This observation of the NFL draft market also happens to show up very strongly in the financial markets. Perhaps you’ve heard the phrase “past performance is not indicative of future results” whispered at the end of commercials or located in the fine print of financial documents. It’s absolutely true, but unfortunately we don’t always believe it. Those who got lucky before and outperformed are no more likely to outperform in the future.
The article goes on to point out that the same relationship holds when you break it down by individual GMs. Much like stock managers, there are a few NFL GMs who routinely outperformed. The issue is that with so many participants, it was exceedingly likely somebody would consistently outperform so there’s still no way to determine whether it was due to luck or skill.
My favorite takeaway of all this, though, is that the article is focused on a market with only 32 participants and concludes that it’s nearly impossible to consistently outperform. What chance does anyone have in the financial markets where there are millions of participants?
