Lampe: Player contracts and investment diversification

From Nick Lampe at Beyond the Box Score on May 7, 2015:

A couple weeks ago, in my finance class, we discussed the concept of Modern Portfolio Theory, which describes how an investor can minimize risk and maximize returns through investment diversification. Naturally, my mind wandered to the topic of baseball, and I began to wonder if this finance concept was applicable to major league teams and the contracts they give to their players. After all, it isn’t too much of a stretch to say that a contract is an investment that a team makes in a player. Furthermore, player contracts, like investments, are inherently risky, since their success is dependent upon future events, which can never be perfectly predicted.

Here is a brief but helpful explanation of Modern Portfolio Theory, courtesy of Wikipedia (I know it’s not the best source, but it will be sufficient for the purposes of this article).

MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets that has collectively lower risk than any individual asset. This is possible, intuitively speaking, because different types of assets often change in value in opposite ways. For example, to the extent prices in the stock market move differently from prices in the bond market, a collection of both types of assets can in theory face lower overall risk than either individually. But diversification lowers risk even if assets’ returns are not negatively correlated—indeed, even if they are positively correlated.

As you can see, the main goal of diversification is to reduce investment risk, and this is achieved through investing in assets that aren’t necessarily related. When assets are truly independent (or very nearly so), they are less likely to move in the same direction. This makes sustaining a big loss very difficult, since a poorly performing investment will often be offset by an investment that does better than expected. Having a portfolio of investments that is not diversified is a huge risk, because all assets will move in the same direction. These assets could all do well at the same time, but they could also fail together, leaving the investor without a backup plan. So in a sense, the principle of diversification is a more complicated way of explaining why it’s not smart to put all your eggs in one basket.

Read the full article here:

Originally published: May 7, 2015. Last Updated: May 7, 2015.