What Investors Can Learn from a Very Alternative Market

From the perspective of an active manager, the promise of behavioral finance is that an understanding of behavior will lead to new exploitable inefficiencies. So far, however, behavioral finance has mainly explained previously known inefficiencies. This article describes a very alternative market in which behavioral ideas have been successfully developed by science and applied in practice. The market is professional baseball, and the active manager is Billy Beane, the general manager of the Oakland Athletics. Behavioral finance has identified several common types of irrational human behavior that may contribute to market anomalies. Among the behaviors are social interactions that lead to following the crowd, oversimplification, and self-deception that produces overconfidence. From the perspective of an active investment manager, the promise of behavioral finance is that an understanding of behavior will lead to new exploitable inefficiencies. Behavioral finance has not yet, however, delivered on that promise. It has helped explain known market anomalies, but it has not led to the discovery of new ones.A very alternative market exists, however, in which the same foibles exist but at least one professional has been able to make use of them to beat “the market.” This market is the world of professional baseball, and it may offer insights into how we can identify exploitable behavior in the financial markets ex ante and apply that knowledge.The “professional investor” of note in this alternative market is Billy Beane, the general manager of the Oakland Athletics. How has Beane led one of the poorest teams in baseball to consistently outperform much wealthier teams—when the prevailing belief is that money buys baseball success? The answer is that quantitative analysis by outsiders of the game identified the characteristics that were truly important to success in baseball; then, Beane observed contradictory behavior (the same foibles discussed in behavioral finance) and exploited those market inefficiencies.Baseball and the financial markets are analogous, but they are not the same. The forces for market efficiency operate much more quickly to eliminate unsuccessful participants in the financial markets. The baseball market is relatively small; the forces imposing efficiency in baseball operate much more slowly—because of the relatively few players, games, teams, and trades, and baseball's protected marketplace. Predicting baseball success is also fundamentally much easier than predicting investment success.Nevertheless, we need to learn a lesson from Beane's approach—namely, the importance of rigorous scientific analysis to successful investing. Irrational behavior may provide opportunities, but clear, rational analysis of market data identifies those opportunities. If exploiting the large behavioral anomalies in baseball required rigorous scientific analysis, imagine how much more important such analysis is for investment management, where anomalies are more subtle and fleeting.