What can the NFL Draft teach us about Investing?

By Dr. Raife Giovinazzo & Dr. Richard Thaler

Fuller & Thaler Asset Management

Every spring, the National Football League draft creates excitement. NFL managers spend millions
on scouting and analysis, trying to select the best rookie players for their teams. In spite of spending
all this time and moneyand the huge stakes involvedmost managers still make big, behavioral
errors! Errors which let smarter managers draft better and win more games. Understanding the
sources of these NFL draft errors can provide useful lessons to stock market investors, lessons we at
Fuller & Thaler apply in our Small Cap Value strategy.

Recently, Dr. Richard Thaler, co-wrote a paper on errors in the NFL draft with Dr. Cade Masseyi.
The primary finding: NFL teams pay too much for the right to pick early in the draft.

For investors, there are two big lessons. First, the best player does not necessarily make the best
draft pickjust like the best company does not necessarily make the best stock to buy. On average
the players taken with first-round picks do not provide teams as much value, performance relative
their cost, as players taken in later rounds. Value matters. Second, NFL managerslike investors
pay too much for glamour, and neglect duller, solid performers. Specifically, NFL managers often
overpay for early round draft picks, so they can draft a glamorous starjust as many investors
overpay for glamorous, fast-growing firms, and neglect solid but less exciting (i.e., value) firms.

In the following, we will explain both lessons about drafting NFL playersand how Fuller & Thaler
applies similar lessons to picking value stocks.

Lesson 1: The best player (or company) does not necessarily make the best pick.

Obviously, teams are not picking players at random, and players taken early in the draft are indeed
better, on average, than those taken later. But football players dont work for free: earlier draft picks
must be paid higher salaries. And because football teams have team-wide salary caps, the salary is
not just a financial cost, it is also an opportunity cost: the more a team pays for one player, the less
money it has to spend on other players. Even Peyton Manning needs linemen to block and
receivers to catch his passes. So the return-on-investment of a draft pick is not just how good the
player turns out to be, but how good the player is relative their cost.

One of the unique aspects of hiring players via a draft is that players have very limited ability to
negotiate their salarytheir salaries are primarily determined by when in the draft they are selected.
And while the NFL rookie salaries are high, they are not as high as the salaries for a veteran player.
In other words, a big benefit of drafting players is that managers can get a great player at a lower cost.
Fans can argue endlessly about whether Peyton Manning or Tom Brady (the 2014 Super Bowl
winner) has been the better quarterback, but there can be no debate about which was a better draft
pick. Manning was selected with the very 1st pick and paid a big salary from day one. Brady was the
199th pick, so for the early years of his contract, the Patriots were getting his services (in football
terms) for next to nothing.ii

FOR INSTITUTIONAL USE ONLY | NOT FOR PUBLIC DISTRIBUTION

Of course, Manning and Brady are just two players. The paper studied all the players selected in the
NFL draft from 1983 to 2008, and for each player computed their surplus value, i.e., the
performanceiii they provide to the team minus their compensation. Heres a graph of the results.
The top line shows that performance does decline as the draft proceedsteams do know
something! The 1st pick has a performance value of about $5 million, while the 33rd pick (the start of
the second-round, given there are 32 teams) has a performance value of about $3 million, i.e., about
three-fifths as much. But while performance declines with later draft picks, compensation also
declines, the second line in the chart. So for any player, their surplus value is their performance
(the top line) minus their compensation (the second line). And heres a result that is shocking to
most football fans. Surplus value increases throughout the first round of 32 teams! And even later
rounds provide almost as much surplus value as the first picks!

Surplus value of NFL draft picks

Value is important when picking playersand when picking stocks. Great firms often make
expensive stocks. Maximizing return-on-investment does not come from just buying the best
companies, it comes from buying stocks most likely to have value relative their current cost. There is a
long line of research showing value stocks have higher returns. For example, an early paper by Dr.
Thaler, Does the Stock Market Over-react proved that long-term winnersstocks with the
highest returns over the past 3 to 5 yearson average have lower subsequent returns. By contrast,
long-term loser (i.e., value) stockslike later draft pickson average provide a better return-on-
investment.iv
Lesson 2: NFL Managers (and investment managers) overpay for glamour.

The second lesson is that NFL managers massively overpay for the privilege of selecting one of those
glamorous early draft picks, just as many investors overpay for glamourous stocks. As we just
established, performance only declines slowly with later draft picks and the surplus value (i.e., the
return-on-investment) actually increases during the first round. So given a choice between picking
1st or picking 33rd, a manager should be close to indifferent.

But what do NFL managers actually do? Well, after teams are assigned their seven rounds of draft
picks (in reverse order of the previous years standings) NFL managers often trade draft picks. And
far from being indifferent between picking 1st or 33rd, NFL managers pay crazy prices to pick earlier.
Consider the 2014 draft, when Buffalo gave up a future first-round draft pick (and more)just to move
from 9th to 4th in that years draft! Based on dozens of trades over the years, the paper estimated the
trade price of any draft pick in terms of other draft picks. The following chart plots the surplus-
value and trade-value of each pick relative to the 1st pick of the draft.

NFL draft picks: The expected Surplus value versus the Trade value
Value relative to 1st pick

As you can see, while the surplus value of a 33rd pick is slightly higher than a 1st pick, the trade value is
just above 0.2, only one-fifth as much! In other words, you could typically trade a 1st pick for five
picks just after the 33rd pickeven though a 33rd pick provides more surplus than the 1st pick. Talk
about an opportunity!
Why does this happen? One behavioral reason is overconfidence. Many teams are just certain that if
they had one of those early picks they could select a player who will be a star. But it turns out that
predicting future performance is really hard. Peyton Manning, a future Hall of Famer, was smartly
taken with the 1st pick of the 1998 draft, but the 2nd pick of the draft that year was another
quarterback, Ryan Leaf, who was a complete bust in the NFL (and is currently busted). And this is
not just one example. If you compare two players at the same position taken consecutively, for
example the 3rd and 4th running backs taken in the draft, what do you think is the chance that the
earlier one will turn out to be the better player? If teams were perfect forecasters the chance would
be 100%; if they are flipping coins it would be 50%. How do teams do? Just barely better than
chance! The player taken earlier has just a 52% chance to be the better player.

Another reason teams overpay for early picks is they over-react to limited data and make extreme
forecasts. Teams dont just predict a player will become an NFL starter, they predict hell become a
superstar. In the 2012 draft, the Washington Redskins were so confident that Robert Griffen III (or
RG3 as he is called) would be a great quarterback that they agreed to an astonishing price to get him.
The Redskins gave up three years worth of first-round picks (and more) to move up to the 2nd pick so
they could get RG3. Although RG3 had a good rookie year, he got hurt, and soon lost his starting
job. Meanwhile, Russell Wilson, a quarterback taken 75th in that same draft, has so far led his team
to two Super Bowls. Overpaying to pick 2nd was a poor investment, and not just in hindsight.

Smart teams can exploit these biases, by selling some early picks to teams ready to pay crazy prices
to pick early, nowand buying later picks in this year and early picks in future years. The teams
that consistently follow this strategy, such as the New England Patriots, win more games as a result.
The paper found smarter draft-pick-trading teams win 1.5 more games per seasona huge amount
in a 16 game season.v

Similarly, smart investors can win in the stock market by trading against biased investors. Research
has found that fast-growing, sought-after stocks earn low returns on average, while conservative,
neglected (i.e., value) stocks earn high returns on average.vi Behavioral biases cause investors to see
high-flying stocks and imagine they will go up forever. Smart investors sell glamorous stocks and
buy neglected stocks instead.

The bottom line for investors

As investorslike NFL general managerswe all have behavioral biases. We are overconfident.
We over-react. The trick to overcoming these biases is to use a disciplined system of checklists and
guidelines that recognize our own biases. At Fuller & Thaler, we have created a system of investing
that overcomes many of our own biases. In our over-reaction (i.e., Small Cap Value) strategy, we
avoid glamorous stocks. We look for struggling, neglected stocks where there has been big and
unusual insider buying or share repurchases. We invest in them not because they are necessarily the
best or most glamorous companies, but because cheap neglected stockslike later round draft
picksare often the best investments and have the opportunity to produce better returns.
About Fuller & Thaler Asset Management:
Fuller & Thaler specializes in applying behavioral finance to investing in the equity market. Our
investment process finds situations where investors behavioral biases are likely to cause mispricing,
creating opportunities to deliver value to our clients. As mentioned in a recent article in Barrons,
Fuller & Thaler manages its Small Cap Value strategy as the sub-advisor for J.P. Morgans
Undiscovered Managers Behavioral Value Fund. If you would like additional information on the
fund please contact your J.P. Morgan Client Advisor or visit www.jpmorganfunds.com/umbvf.
Dr. Raife Giovinazzo is Director of Research at Fuller & Thaler Asset Management. Dr. Richard
Thaler is a professor at the University of Chicago, and author of the new book Misbehaving: The
Making of Behavioral Economics, coming out May 18th.

Disclosures

This information is provided solely for general informational purposes and does not constitute an offer to sell
or a solicitation of an offer to buy or sell any product or service to any person or in any jurisdiction where
such offer or solicitation would be unlawful.

The manager seeks to achieve the stated objectives. There is no guarantee the objectives will be met.

Unless otherwise noted, Fuller & Thaler Asset Management, Inc. is the source of the illustrations and
performance data. Information is derived using data from independent research resources that are believed to
be accurate. The potential for profit is accompanied by the possibility of loss. Past performance is not
indicative of future results.

This document is intended solely to report on various investment views held by manager. Opinions,
estimates, forecasts, and statements of financial market trends that are based on current market conditions
constitute our judgment and are subject to change without notice. We believe the information provided here
is reliable but should not be assumed to be accurate or complete. The views and strategies described may not
be suitable for all investors. References to specific securities, asset classes and financial markets are for
illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations.
Indices do not include fees or operating expenses and are not available for actual investment. The
information contained herein employs proprietary projections of expected returns as well as estimates of their
future volatility. The relative relationships and forecasts contained herein are based upon proprietary research
and are developed through analysis of historical data and capital markets theory. These estimates have certain
inherent limitations, and unlike an actual performance record, they do not reflect actual trading, liquidity
constraints, fees or other costs. References to future net returns are not promises or even estimates of actual
returns a client portfolio may achieve. The forecasts contained herein are for illustrative purposes only and
are not to be relied upon as advice or interpreted as a recommendation.

JPMorgan Funds are distributed by JPMorgan Distribution Services, Inc. (JPMDS) and offered by J.P.
Morgan Institutional Investments, Inc. (JPMII); both affiliates of JPMorgan Chase & Co. Affiliates of
JPMorgan Chase & Co. receive fees for providing various services to the funds. JPMDS and JPMII are both
members of FINRA/SIPC.

Contact JPMorgan Distribution Services at 1-800-338-4345 for a fund prospectus. You can also visit
us at www.jpmorganfunds.com. Investors should carefully consider the investment objectives and
risks as well as charges and expenses of the mutual fund before investing. The prospectus contains
this and other information about the mutual fund. Read the prospectus carefully before investing.
There is no assurance that behavioral finance strategies will protect against the loss of capital.

The Fund may invest a portion of its securities in small-cap stocks. Small-capitalization funds typically carry
more risk than stock funds investing in well-established "blue-chip" companies since smaller companies
generally have a higher risk of failure. Historically, smaller companies' stock has experienced a greater degree
of market volatility than the average stock.

J.P.Morgan Asset Management is the marketing name for the asset management business of JPMorgan Chase
& Co. and its affiliates worldwide

i Massey & Thaler (2015) The Losers Curse: Decision-Making & Market Efficiency in the National Football
League Draft, Management Science. For more details, see the link on our web site: www.fullerthaler.com.
ii After four or five years players become free agents and teams have to pay the market price if they want to

retain their services.

iii Performance value is estimated as the compensation cost of a similarly talented (based on starts, pro-bowl

appearances, etc.) free-agent player who was not subject to the rookie draft salary limitations
iv De Bondt & Thaler (1985) Does the Stock Market Overreact? Journal of Finance
v In regressions, a one standard-deviation improvement in draft-pick-trading gives 1.5 more wins per season.
vi Two examples of many: Cooper, Gulen & Schills 2008 paper in the Journal of Finance finds that stocks with

fast-growing assets earn lower returns while stocks with slow-growing assets earn higher returns. Da,
Engelberg & Gaos 2011 paper, In Search of Attention, finds stocks that experienced high google search
activity earn lower returns over the next year.

For more details about the NFL draft pick up a copy of Dr. Richard Thalers new book,
Misbehaving: The Making of Behavioral Economics, coming out May 18th.