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WHAT BASEBALL CAN TEACH INVESTORS – Jonathan Baird CFA – Medium

By Jonathan Baird CFA All Rights Reserved www.globalinvestmentletter.com

There is great value in identifying principles that produce success in one activity and applying them in another. Investing has been described as a game, and it does share many of the characteristics of games or, indeed, any pursuit that requires the use of strategy. Of course, the level of applicability of principles will vary by activity. I believe the game of baseball is particularly well suited to providing useful lessons for better investing as discussed in the paragraphs below.

GOOD PITCHING BEATS GOOD HITTING

This old chestnut is recognized as a truism by any seasoned baseball fan. Time after time, one sees a great hitting team shut down by an opposing team’s top starting pitchers. This concept is related to another old sports cliché that “defence wins championships”. The importance of a strong defence is recognized across all team sports. The reason defence possesses the advantage is that it is an easier strategy to implement than offensive action, which typically requires surmounting a greater number of obstacles to succeed. In baseball, scoring a run requires, except for the home run, multiple hits and/or walks as well as running the bases efficiently. The defensive team needs only catch the ball. Defence is also recognized as having the easier role in warfare; most military thinkers recommend at least a 3 to 1 advantage by the attacking side to produce a high probability of success.

For investors, a sound defence rests with prudent money management. Prudent money management requires that position size should be kept small enough that losses, or indeed a string of losses, will not have a material impact on the portfolio. Batters can both go on hot streaks and endure painful slumps, and so can investors. Adopting a defensive posture with appropriate position sizes and having a policy in place to limit losses is integral to increasing the odds that an investor will reach the end of his or her investing “season” with satisfactory results. It is well to remember that a portfolio that declines by 50% must then rise by 100% to reach breakeven. The mathematics of investing makes clear that “defence wins championships.”

BALLPLAYERS ARE OFTEN MOST VALUABLE BEFORE THEY PLAY A MAJOR LEAGUE GAME

The vast majority of minor league baseball players, even the most highly regarded, will not succeed at the major league level. Every baseball fan has seen an array of “can’t miss” minor league prospects fail to make an impact in the majors. In fact, fewer than 20% of prospects become impactful big-league players. However, highly regarded minor leaguers are highly sought after by other teams who will often trade established major league players for one or more “prospects”. The appeal of successful minor leaguers is that their futures are unsullied by failure in the major leagues. The perceived potential of these players is limited only by the imagination of observers.

Human beings commonly extrapolate recent behaviour into the future, not least in sports and investing. This makes trading minor league talent for proven major leaguers the most cost-effective means to strengthen a baseball club as teams as able to trade uncertain minor league prospects for high ticket proven players. Certainly, occasionally a minor league prospect who is traded subsequently becomes a major league star, but such trades are more than offset by the many minor leaguers who fail in the majors.

An analogy can be found in the investing world with early-stage companies. In many cases, a young company with a compelling story will be able to raise funds at the best terms before it has appreciable revenue. These young companies can offer enticing (and seldom met) pro forma financial projections that stir the imaginations of potential investors without as yet being exposed to the trials of the marketplace. Early stage companies, particularly in the technology sector, can garner enormous valuations if their “story” is suitably intriguing and they are well marketed. For every success like Facebook or Google, there are dozens of start-ups that raised considerable amounts of capital….and ultimately failed.

Investors must remember that like young ballplayers, investments without a solid track record carry much higher levels of risk than investments that have weathered a business cycle or two. Wise investors recognize that the majority of young companies (even the most attractive) will not succeed and temper their enthusiasm accordingly.

EMPLOY QUANTITATIVE ANALYSIS TO MAKE BETTER DECISIONS

The evaluation of baseball players prior to the pioneering work of Bill James in the late 1970s was primarily a subjective assessment based on wisdom from previous generations. Player performance was judged using a narrow range of traditional statistical measures such as batting averages. Baseball strategy was similarly based on traditional concepts. The great service Bill James performed for baseball was turning a critical eye to the accepted wisdom of the game. James revealed that the ability of a player to get on base, i.e., prevent making an out, made a far greater contribution to a team’s offence than the long-held standard of batting average. As well, James’ work demonstrated that stolen bases and sacrifice bunts were of less value than traditionally assumed. The pioneering work of Bill James attracted others to the field, those who made their own contributions to the understanding and development of the game. Today virtually every major league team uses quantitative techniques, including probability theory, in player evaluation and game strategy.

There is certainly no shortage of information available to investors for quantitative analysis. The biggest challenge is the proper interpretation and use of the information provided. Investing, like baseball, features few certainties. In an uncertain world, one must learn to think in terms of probabilities. Just as no batter can expect a hit every time at the plate, no investor can expect every trade to be profitable. Thinking in terms of probabilities encourages an investor to gather and apply information in a manner that maximizes the likelihood of a successful outcome. Investors who use probability theory seeks to put the “odds” in their favour, recognizing that certainty is impossible. The act of attaching probabilities to outcomes also helps temper the emotional aspect of investing, which is a challenge for all investors. Thinking in a probabilistic manner makes the investment research process more efficient by focusing attention on the factors that most affect the chances of a successful outcome. As well, the recognition of probabilities rather than certainties encourages the adoption of sound money management practices to maximize gains and minimize losses.

In investing, as in baseball, there remains an important role for qualitative analysis. This is particularly true for investors in this era of interconnected markets and economies. The current global geopolitical environment is the most tenuous since WWII. Future events resulting from current tensions will have profound impacts on society in general and investors in particular. The interpretation of geopolitical events is not easily done quantitatively, which makes qualitative and quantitative approaches, working in tandem, the most effective approach to successfully navigating the markets of today and tomorrow.

THINK IN LARGER TERMS AND ACCEPT CHANGE

Baseball is by far the oldest of the major North American professionally played sports and in many ways still the most traditional. However, the game has changed since the first professional teams played in the 1860s. The rules have changed, some in subtle ways and others in more dramatic form, e.g., the gradual reduction in the number of balls required for a walk to the current 4 from as many as 9 in the 1870s. The implementation of the designated hitter rule in the American League was a major departure from tradition that has still not been adopted by the National League.

The biggest change in baseball since WWII is in the people who compose the teams. It seems astounding today, but prior to 1947, no African American played in the major leagues. The addition of Jackie Robinson to the lineup of the Brooklyn Dodgers not only introduced fans to the best second baseman of his day but allowed for a long line of great African American players to improve the general calibre of play in major league baseball. Subsequently, the presence of Latin American players grew and further improved the quality of play. Major league teams have more recently taken to looking for talent more farther afield, and the number of major league players from Japan, Korea, Canada, etc., has become significant. It is natural that the quality of play will improve if one is drawing from a larger pool of talent.

Many investors, reminiscent of baseball before 1947, are content to embrace the status quo and practice what is comfortable. Therefore, a majority of investors are content to restrict their activities to their domestic markets and/or pursue the same investment techniques regardless of changing times. All investors would be better served by broadening their horizons and investigating foreign markets and new asset classes. This process requires some investment of time in education, but the rewards are substantial. Like baseball teams who don’t restrict where their players come from, investors who select their investments from a broad selection of markets will experience better results. Investing from a broader range of choices, which promotes diversification, will also lower portfolio risk. At the very least, cultivating an interest in a wider range of markets and asset classes will provide valuable context for evaluating one’s own domestic market.


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