Financial advisors looking to understand how emotion can botch an investment decision need to look no further than the National Football League draft.
Richard H. Thaler, a professor of behavioral science and economics at the University of Chicago Booth School of Business and co-author of the best selling book Nudge, set out to with a former student to investigate their hunch that teams overvalue picking early and pay too much for top draft picks, including trading other picks.
And the results matched their theory, Thaler told the audience at IMCA’s annual conference in National Harbor, Md. on Monday. As an example, look to the Washington Redskins this year, he said. That team had the sixth spot and traded with the St. Louis Rams for the second spot, moving up four picks.
To make that trade, the Redskins sacrificed their first round pick next year, their first round pick the following year and the second round pick this year. Altogether, that makes for a “huge price,” Thaler said.
“What we investigated was whether it’s a smart strategy to pay up. And the answer is no. You should trade down,” Thaler said. “In terms of the surplus the team gets, the sixth pick is actually worth more than the second.”
For teams that trade a third round pick this year for a second round pick this year, the interest rate for that one round up amounts to 176%, Thaler said from his calculations.
“These football team owners are all billionaires,” Thaler said. “I think it’s safe to assume that they didn’t get to be billionaires by borrowing at 176% rate of interest. But they’re so desperate to win that they get emotional and fall in love with a player.”
The smartest teams do two things: trade down and lend. Thaler and his student, who wrote a paper on their research, currently advise one NFL team on their decisions, which still can be tough, Thaler said. That team, like others, can be guilty of falling in love with a player and believing they will solve all of their problems, he said.
The team that consistently trades down or trades a current pick for future picks is the New England Patriots. Team head coach Bill Belichick was an economics major at Wesleyan University, has read Thaler’s research paper and understands it, Thaler said.
“That’s not the team we work for, because Belichick just read the paper and doesn’t have to pay us,” Thaler said.
Financial advisors who are looking to get a sense of the behavioral tendencies of their clients often turn to risk tolerance questionnaires. But Thaler thinks those tests might not be the more accurate measure.
“People don’t know their risk tolerance,” Thaler said. “Even as individuals, we’re not consistent.”
Someone who skydives regularly might have all of their investments in Treasury bills, Thaler said. Whether that person is aggressive or conservative depends on the domain.
Thaler said he has worked for years on developing a more accurate questionnaire to evaluate a client’s risk tolerance, and is not sure it is possible.
“I think there might be a better way to do it that might be a very high tech way to do it that would involve putting people into scenarios where they could actually live through something,” Thaler said.
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