Moneyball and Market Efficiency

As the baseball season starts to move into full swing, I start to think about stats and who is playing up to their potential. Are there opportunities to find undervalued players?

One of the best illustrations of market inefficiency and the competitive responses of markets is found in Michael Lewis’s book MoneyBall: The Art of Winning an Unfair Game. The premise in Moneyball is that on-base percentage, a statistical measure of a batter’s value, was undervalued in the major leagues. There was inefficiency in the labor market. This inefficiency was effectively exploited by the Oakland Athletics as a means of leveling the playing field for poor market teams which did not have the money to buy top talent. They were able to successfully form winning teams based on measures that others did not use.

The take-away for investors is straight-forward. You should look for hidden value through using alternative methods of analysis. Unfortunately, when you find this hidden value your success will cause others to emulate your behavior. Markets are dynamic and others will enter the market to also exploit these same opportunities. These activities led to market efficiency. There is no free lunch that can be continuously exploited.

Using a very general definition, market efficiency is the ability of prices to respond quickly to changes in the underlying value of a market. It is the result of a perfectly competitive market. Once this anomaly or opportunity to exploit hidden value is used up, you have to go onto a new strategy that can create value.

If you do not believe in the efficiency of markets like baseball, read Jahn Hakes and Ray Sauer in their Summer 2006 Journal of Economic Perspectives paper, “An Economic Evaluation of the MoneyBall Hypothesis”. They found that the market inefficiency discussed in the book, on-base percentage, disappeared within a year of its publication. Teams found this to be a successful measure of a player’s worth, so they bid up the salaries of those who had high on-base percentage relative to home run hitting. The labor market became efficient or eliminated what was perceived to be cheap value.

Next time you go to a baseball game, think about hidden value and how fast it may be revealed and eliminated. Could the same thing happen with the alpha of many investment strategies?