Before you invest in the next Chris Davis, consider recent Wall Street investment bubbles

By Brian Mills

Before my fantasy baseball auction, I usually gather as much research as possible to get an accurate estimation of a player’s value. Over on The Book Blog, Tom Tango has shown that one single projection system can be an inferior predictor of baseball stats than the aggregation of multiple projection systems. Put together, these expert projections essentially set a market value for every player in baseball.

This is similar to what arbitrageurs on Wall Street end up doing in financial markets.  Arbitrageurs try to gain profit by using proprietary data and models to uncover undervalued assets. Ultimately, by exploiting market inconsistencies, the collected efforts of arbitrageurs often result in closing down valuation gaps within a market.

The downside of this approach is that arbitrageurs will often rely on each other to assess risk in their models, rather than do so independently. When an asset doesn’t perform to expectation, the consequence is that most people will get things wrong. As we witnessed recently in the economy, the interdependent nature of everyone’s valuation and risk assessment can lead to severe bubble bursts.

An investor may put money in a company’s stock anticipating huge returns, and lose his shirt because he couldn’t step away from the community assessment. In fact, by cross-referencing the models of others, an investor is liable to bigger losses due to grossly underestimating risk. Many investors may convince themselves that if everyone else is making a certain bet, there must be security in popular behavior.

What does this have to do with fantasy sports?

Every year, fantasy pundits tout sleepers for breakout seasons. Opinions are strong, leading fantasy owners to increase their valuations of these players. Last year, players like Chris Davis and Brandon Morrow quickly moved up the ranks of expert mock drafts. As owners convince themselves of a player’s  great perceived value, they begin to become more aggressive in targeting that player.

Now we get to the problem of re-evaluation of risk. Players may become more highly valued, but their risk portfolio shouldn’t change. Nevertheless, by leaning on the assessment of others, owners who drafted Chris Davis last year suffered catastrophic losses. A player like Davis would not have lived up to his draft grade in the 10th round, but an owner’s loss was magnified when the Davis hype elevated him to 5th or 6th round status. The information circle created a bubble, raising the price and lowering the perceived uncertainty about Davis’ performance.

The moral of the story for owners is to be extremely careful when reaching for sleepers.

While it’s important to know who breakout candidates are, reevaluating the risk involved in a breakout can have detrimental implications on your fantasy season.  It’s important to ensure mostly objective evaluation of risk, rather than re-evaluation due to other confirmatory models using very similar data.  The less heralded a sleeper is, the less likely he is going to break-out, but the more likely that you’re going to see a profit on your risky investment.

Remember that the higher the reach, the bigger the crash and the less expected surplus for that reach.  It may sound redundant, but if someone picks the sleeper early, that’s okay.  You don’t want him there anyway.