Player contracts and investment diversification

A couple weeks ago, in my finance class, we discussed the concept of Modern Portfolio Theory, which describes how an investor can minimize risk and maximize returns through investment diversification. Naturally, my mind wandered to the topic of baseball, and I began to wonder if this finance concept was applicable to major league teams and the contracts they give to their players. After all, it isn't too much of a stretch to say that a contract is an investment that a team makes in a player. Furthermore, player contracts, like investments, are inherently risky, since their success is dependent upon future events, which can never be perfectly predicted.

Here is a brief but helpful explanation of Modern Portfolio Theory, courtesy of Wikipedia (I know it's not the best source, but it will be sufficient for the purposes of this article).

MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets that has collectively lower risk than any individual asset. This is possible, intuitively speaking, because different types of assets often change in value in opposite ways. For example, to the extent prices in the stock market move differently from prices in the bond market, a collection of both types of assets can in theory face lower overall risk than either individually. But diversification lowers risk even if assets' returns are not negatively correlated—indeed, even if they are positively correlated.

As you can see, the main goal of diversification is to reduce investment risk, and this is achieved through investing in assets that aren't necessarily related. When assets are truly independent (or very nearly so), they are less likely to move in the same direction. This makes sustaining a big loss very difficult, since a poorly performing investment will often be offset by an investment that does better than expected. Having a portfolio of investments that is not diversified is a huge risk, because all assets will move in the same direction. These assets could all do well at the same time, but they could also fail together, leaving the investor without a backup plan. So in a sense, the principle of diversification is a more complicated way of explaining why it's not smart to put all your eggs in one basket.

Based on my initial observations, this theory appears to have practical implications for the game of baseball. As I stated earlier, baseball contracts can be seen as a form of investment. In addition, the expected performances (or returns on investment) of individual players appear to be mostly independent of each other. True independence probably cannot be achieved since there are team/organizational factors that could affect all players. We now have the advanced metrics available to look at player performances on a purely individual basis and ascertain how much value a player adds to his team individually.

If we can safely say that the principle of diversification generally holds true in the context of baseball, then what contract situations would we be able to apply it to?

The concept of diversification certainly seems relevant to teams choosing whether or not to give a star player a massive contract. While it is true that a star player in his prime is a very valuable commodity, teams must always consider whether they can get more value by spending the same amount of money on multiple second-tier players instead. Investing a lot of money in one asset is always a big risk, and this is particularly true in baseball, where the risk of injury is a threat for all players, no matter the size of their contract.

One of the most notable examples of a team taking the risk of investing a lot of money in one player is the Albert Pujols contract. After the 2011 season, the Angels gave Pujols a ten-year, $240 million contract after the Cardinals refused to make an offer that high. We are just over three years into the contract, and it has consistently ranked high on the list of the worst contracts in baseball, due to the fact that Pujols has missed time with injury and performed at career low levels.

The Cardinals were able to use the money they saved from not signing Pujols and give it to multiple players. They replaced Pujols by signing Carlos Beltran (Allen Craig shifted from right field to first base) for two years and $26 milion, and they also had the money to give contract extensions to Yadier Molina (five years, $75 million), Adam Wainwright (five years, $97.5 million), and Matt Carpenter (six years, $52 million). When Beltran left, the Cardinals were able to sign Jhonny Peralta (four years, $53 million), who quietly lead the team with 5.3 fWAR last season. Perhaps the Cardinals would have been able to make some of these deals even if they had kept Pujols, but there is no doubt that his contract would have severely limited their payroll flexibility.

While the Cardinals may not have anyone who is paid like a true superstar (Matt Holliday's seven year, $120 million contract is the largest in franchise history), they have a lot of very good players who collectively make them one of the best teams in baseball. The Cardinals, who have the 12th highest payroll in baseball, are not a cheap team by any means, but they have lowered the risk of their contracts by investing moderate amounts of money in multiple players instead of a high amount of money in one single player.

The Tampa Bay Rays are another team that has successfully used this strategy, despite being in a situation very different than that of the Cardinals. In the offseason preceding their 2008 run to the World Series, the Rays started a pattern of extending talented players who had very little service time. Over last seven years, the Rays have given out these types of extensions to James Shields, Evan Longoria, Scott Kazmir, Ben Zobrist, Wade Davis, Matt Moore, and Chris Archer.

Giving extensions to players with little major league track record is certainly a gamble, especially for a low-budget team like the Rays. Through diversification, though, the team has spread out the risk into a high number of players, preventing them from being hurt too much by a single underperformance or injury. For example, Scott Kazmir was not extremely effective with the Rays in the two years after his extension (he was traded before the end of the contract), but the team more than made up for this loss through players like Evan Longoria and James Shields, who provided a lot of surplus value to the team.

The principle of diversification has been proven to be a successful tactic in the field of investments, and its basic framework can be applied to the game of baseball. While there are certainly other strategies that teams can use to successfully construct a roster in a cost-effective way, diversification can help teams reduce the amount of risk in their player contracts. By investing payroll resources in a high number low to moderate cost players, teams can avoid being overly dependent on the performance of a single high-paid player and have a better chance of achieving sustained success.

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All statistics courtesy of FanGraphs. Contract information courtesy of Cot's Baseball Contracts and MLB Trade Rumors Extension Tracker.

Nick Lampe is a contributor at Beyond the Box Score and Viva el Birdos. You can follow him on Twitter at @NickLampe1.