Stories | May 31, 2016

Why spending big won’t guarantee a win – in football or investing

You get what you pay for is a traditional mantra we hear everywhere and it seems footballer salaries are no different. But does it follow that the highest paid team is most likely to win?

Sports writer Simon Kuper and economist Stefan Szymanski, in their acclaimed book Soccernomics, show that players largely earn what they are worth, judging by their contribution to their teams’ performance. A club’s wage bill is an important influence on where that club finishes in the league.

In their analysis, clubs that paid the highest wages typically came top of a game series while the clubs that paid the least came last. However, in any single match, a squad with a high wage bill can be beaten by a team receiving lower wages. This is a classic underdog, “David versus Goliath”, kind of scenario.

How does this happen?
In investment theory, this reflects ideas about idiosyncratic and market risk. Idiosyncratic risk is specific to an individual share, asset or firm and is generally unpredictable. For example, sometimes an individual or company develops a product that becomes very popular – even if similar products exist in the market.

Think about the rise and continuing success of computer company Apple. And sometimes bad luck such as poor weather can wreck a retailer’s results. Market risk, on the other hand, applies to an entire asset class based on wider economic conditions.

But sometimes it is just not possible to calculate the risk, as the impression of risk can be subjective. Sometimes, “things happen”. This is where we fall into the realms of uncertainty - as latest findings in the ING International Survey - Cup-o-nomics 2016 reflect.

In any single match, a squad with a high wage bill can be beaten by a team receiving lower wages, a classic ''David and Goliath'' kind of scenario.

Why the underdog can win
Economist Frank H Knight wrote about this distinction between risk and uncertainty in his in his 1921 book, Risk, Uncertainty, and Profit. He said that risk applies to situations where we do not know the outcome of a given situation, but can accurately measure the odds.

However, uncertainty applies to situations where we don’t even know the possible outcomes of a situation, let alone their odds or probability. This is known as Knightian uncertainty. When investors realise their assumptions about risk aren’t working and that conditions of uncertainty apply, markets can witness “destructive flights to quality”. This is when investors rid their portfolios of everything but the safest of investments, such as US Treasury bonds.

Guard against uncertainty
For most of us, that means holding some assets in liquid, low risk ways against such uncertain times. Having an emergency fund makes sense – even for the most sophisticated investor.

And this also gives hope to teams without deep pockets, partly explaining Leicester City’s UK Premier League win in spite of 5,000-1 odds. Who would have bet on that?

eZonomics team
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