A Litte Baseball

Baseball before Moneyball

In a word: stats.  Baseball has statics for almost anything of relevance that happens on the field.  Finance has statics like expense ratio, yield, price-to-earnings ratio, total return, alpha, beta, R-squared, Sharpe ratios, and the Greeks (delta, vega, theta, rho)… just to name a few.  I  suspect most of my readers are more familiar with baseball stats like batting average, on-base percentage, slugging percentage, OPS, ERA, K%, BB%, GB, and the like.

Today’s blog will start with the simple concept of batting average.  In baseball batting average is the number of hits divided by the number of official at bats.  Since a typical baseball player can have 400 at bats per baseball season, there is a lot of statistical significance to his batting average for one year.

In contrast, a fund manager could be said to have about 4 at bats per season — one per quarter.  It would take a 100-year career to have as many “at bats” as baseball player has in one.  Even if you decided to count fund performance on a monthly basis, it would take 25 years to match a baseball season’s worth of data.

The most common financial definition of batting average counts a hit as outperforming the market (say the S&P 500) over a given time period, say 3 months.   An out is under-performing the market.  Generally a .500 batting average is analogous to the the Mendoza line in baseball.  Sadly, many fund managers and financial planners bat below .500.   And often those that do exceed .500 get there by early luck… luck which generally fades (back below .500) with time.

Just like in baseball batting average is not the most useful static in finance.  OPS (on base plus slugging percentage) is probably a better financial stat… if it existed.  Instead financial stats like Sharpe Ratio and alpha fulfill a similar role of financial performance measurement.  The problem with all these financial stats for measuring fund managers is there are simply not enough “plate appearances” to reliably measure a fund manager’s performance until his or her career is almost over!   It is only after a long financial career that the difference between skill and luck can be accurately sorted out… a bit late I’d say for investors looking to pick fund or fund managers.

There is a factor other than stats that financial and baseball matter share.  In a recent conversation someone mentioned that baseball is the only major sport where the player scores [directly].  In other words the runner himself (herself) scores by getting safely to home plate.   Basketball, football, and hockey require an object (ball or puck) to cross a threshold.  Football requires a ball + a player to score a touchdown, but a field goal does not directly require a player to fly through the uprights!  Only in baseball does the player himself score a run.

This analogy can be extended to the idea that the investor herself can be the only thing that matters (that scores).  At the end of the day it the investor who determines how successful she is at meeting her financial goals.  The Sabermetrics of finance may help her get there, but ultimately it is the investor herself who has a winning, losing, or World-Series-Championship financial season.

The rule of 72 is an easy way to make fast financial calculations in your head (or on a sheet of paper)… no calculator is necessary.  The idea is that you can determine how fast money will double based on an interest rate or rate of return.  Divide 72 by the interest rate and that is the number of years it will take for the investment to double.

For example if a CD (Certificate of Deposit) is paying 6% it will double in 12 years because 72/6 = 12.

The rule of 72 can be used for decreases in value, such as inflation.  If inflation is 4%, money under a mattress loses 4% per year in value.  Because 72/4 = 18, that money’s value will be cut in half in 18 years.   So positive returns divided into 72 tell how long it will take your investment to double and negative returns how long to lose half its value.

The rule of 72 provides convenient illustration of how fees can effect an investment.  Let’s say you are considering two investments in your IRA managed by your brother-in-law Sam.  Option A is to buy and hold SPY, an index fund that has an expense ratio of virtually 0% (0.09% actually) or option B tracking the same index  but managed by the Sam’s company with a 2% expense ratio.  Sam says “Hey buy my index and I get a commission and a chance to win a boat.” Using the rule of 72 you see that 72/2 is 36, meaning Sam’s index will only be worth half of SPY in 36 years.  If you are 29 years old and want to retire at 65 (in 36 years) that’s half of your retirement money!  Tell Sam to find some other sucker to win his stupid boat.

Rule of 72

Cost of 2% based on the Rule of 72

Finally you can use the rule of 72 together with inflation and expected return to plan your financial future.  If you expect a 7% (nominal) return on your retirement portfolio and 3% inflation, that’s a 4% annual return, so your money will double — in inflation-adjusted terms — in 18 years.  Now if inflation is 4% your real return is 3% and your real investment value will double in 24 years; that’s a whole 6 years longer.  Possibly 6 more years until you retire.  Add a 1% management fee and your real return drops to 2% and doubling time is now a whopping 36 years.  Yes, even a 1% fee can cost you 12 more years until you retire!

The example above shows the destructive power of inflation and why even a 1% annual inflation underestimation can be a big deal.  For tax payers that means tax brackets (based on the government’s CPI-U) gradually form an increasingly tight straight-jacket around your take-home pay.  For Social Security recipients this means cost of living adjustments that simply don’t keep up with real world expenses.

The rule of 72 is a powerful tool for financial estimation.  The rule of 72 is not perfectly accurate, but it is generally pretty close to the target.  It is, however, easy to use and can be used to explain financial concepts to people that aren’t that “mathy”.  It is a great way to start explaining finance to kids; while being a tool powerful enough that is also used by Wall Street pros.

Human Capital

On April 27, 2011, in finance blog, zen, by Dave

From a financial perspective, we are more than our (paper) net worth.  We also possess something economists call “human capital”.  I’d call it expected earnings potential.  Whatever you call it, it is an asset and is worthy of upkeep and proper maintenance.

So lets say you’ve learned some valuable skills and have a desk job with a comfy office chair… and free juice and soda.  Well, cool — until your age surpasses your waste line.  Your waste line gets jealous and tries to catch up.  This is not cool.  It is time to start exercising your human capital — literally.  (Or swear off the soda.)

Some financial advisers would say its time to think about insurance, especially life insurance.  Possibly.  I’m thinking the best returning investments are exercise and diet.  One’s a four-letter word and the other is even more unpleasant.  Both, however, pay dividends.  Benefits include longer life expectancy, better wellness, healthier appearance, and often improved mental function.  Yes, your mileage and results may very, and please consult your doctor.  Keeping yourself fit and healthy is a good investment.  It is often challenging and frustrating, but many investments in the self are.

Another investment to consider is education and training.  I’ve read articles saying that a master’s degree beats a bachelor’s degree, even after educational expenses and a ~2 year delay in entering the workforce.  I’ve also read publications claiming the opposite.  I think its a toss up and depends on many factors including major.  What I strongly believe is that a four-year college education is both financially desirable as well as rewarding for many people, and that in general state colleges and universities provide a better overall return on investment than expensive private colleges.

I also believe that there is such a thing as too much school, from a financial standpoint.  In many fields, a Ph.D. is no more valuable than an M.S., and is sometimes even a liability.

Some folks are not that into traditional classroom-based learning.  I love the classroom, but if I had the talent (aka a better arm, better glove, better hitting, and better speed) I’d be a professional baseball player.  Right fielder for the San Diego Padres sounds perfect.  Sorry, Will Venable, I want your job.

The long and short of this financial blog post is that an important component in investing in your financial future involves investing in yourself.  For me that takes a lot more emotional effort.  Nonetheless, I am making that effort.

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Inquiring minds want to know, how profitable is Major League Baseball?  Well, the inside baseball says “very profitable”.  This after a surreptitious release of Pittsburgh Pirates’ confidential financial documents.  Which makes me wonder, how did the LA Dodgers drop the big money ball?

Well, in the business of baseball, it appears that its all about winning the mighty dollar.  I’m actually impressed.  Major League Baseball is, after all, a business and the cliche “business is business” applies.

One parting thought:  What would baseball be like if there was a baseball team owned like the Green Bay Packers?

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If I was asked to investigate buying a (Major League) baseball team, I’d start by building a mental model of the finance of baseball.  I’d start by observing that a team consists of 1) a roster of players, 2) an collection of player contract and player and pick options, 3) a management and coaching team, 4) a stadium and stadium support staff, 5) league contracts and obligations,  6) marketing, television, and media rights and contracts, 7) financial assets and liabilities,(8) ball park ticket and concessions sales.   Well, that’s a start anyhow.

I’d then consider the competitive environment.  It consists of other ball clubs and is played about half of the time on other ball fields.  Naturally AL vs NL is an important consideration.   Generally, wins lead to more revenue, and better (more expensive) players contribute to more wins.  However, that is not always the case.

A baseball team aptly called a baseball franchise.  It exists as a privately owned piece of a larger governing organization.    That larger organization makes all sorts of rules that effect everything from the buying and selling of franchises to the “luxury tax” paid by high-payroll teams such as the Yankees.

I’d love to get my hands on a MLB franchise’s income statements and balance sheet, say for the Chicago Cubs.  I wonder if they made or lost money in the last decade?  I’d be curious to see what correlation there was between their revenue and their win/loss record for each season.  I’d wager that the Chicago Cub’s win/loss-to-revenue correlation is much less than that of most other MLB teams… simply because the Cubs fan base is more forgiving of (or simply more used to) losing.

So, an MLB baseball team is a privately-held franchise of the larger MLB organization.  Similar to a McDonald’s franchise being part of the the larger McDonald’s Corporation.  A key difference being that MCD is publicly traded whereas MLB is not.  (And, of course, a baseball franchise is way more expensive that a McDonald’s franchise.)

Switching gears, consider the derivatives market surrounding baseball (and other sports).  I’m referring to sports betting.    In Nevada alone, sports betting exceeds 2 billion dollars per year.  Many sports bets are analogous to binary options… they either pay nothing or 2X (less the vig) depending on the outcome of a game (and the point spread).

I’ve been rather unmotivated to update this financial blog lately.  The reason?  Taxes!  I generally like to keep the tone of this blog upbeat, and when taxes are on my mind my tone tends to be closer to beat up.  Speaking of… my tax payment checks are going in the mail today.  My property tax checks will be going out next month.

However, baseball season is now underway, and that is good.  And my softball league will start up next month… one of the highlights of summer for me.  I wonder how much complicated MLB player’s taxes are and how many states they have to file in?  Also US military personnel.  If I made the rules, US soldiers would not have to pay single cent of tax on their wages while in combat tours.

Whoops, I’ve done it again!  Thinking about taxes and spoiling the prospect of a good mood.  So on to the topic of gold.  I can’t seem to go anywhere with out seeing or hearing either “We buy Gold!” or buy physical gold from us because someone thinks gold will go to $2000 per (troy) ounce.

If I had some gold trinkets or coins sitting a drawer somewhere — gold items that didn’t have any sentimental value to me — I’d get some local cash quotes, pick the highest, and sell.  But as for buying gold… nah… I’d rather buy index funds or black gold, in the form of ETFs XLE and/or VDE.  In fact I currently own XLE, VDE, SPY, VTI, SCHB to name a few.

Well, I’ve got to cut off this financial/baseball/gold/taxes blog post early, as I’ve got to run the dog to advance canine training class.  Best investing wishes, and may taxes not bite too deeply this year.