Legendary NYU finance professor thinks that investors can learn a valuable lesson from Major League Baseball.
"As any baseball fan knows, the New York Yankees have an A Rod problem," he writes. "Just in case you have no idea what I am talking about, A Rod is Alex Rodriguez, the third baseman for the New York Yankees, signed in December 2007 to a one of the richest sports contracts in history."
Unfortunately, Rodriguez has been so disappointing that the Yankees even benched him during the playoffs. And the Yankees still owe him $114 million over the next five years.
If the Yankees continue to expect Rodriguez to fall short of expectations, what are they to do?
Damodaran advises that Rodriguez's contract should be seen as a sunk cost. He writes:
If they follow financial first principles, the contractual commitment of $114 million that they have already entered into should not be part of the calculus in any decision that they make now. Thus, if they feel that A Rod, based upon his current skill level (and age), is worth only $3 million a year for the next 5 years, they should be willing to consider trading him to another team (assuming he okays the trade) that will offer even a little bit more (say $3.1 million/year) in return, and eat the rest of the contract (about hundred million).
This would be the rational thing to do. And this way of thinking is fundamental in corporate finance and investments.
However, Damodaran doesn't expect the Yankees to go that route.
Will they do it? I don't think so, because any such deal be an explicit admission that they made a horrendous mistake five years ago. Instead, what you are most likely to see is A Rod at third base for the Yankees, to start the next season, with everyone hoping and praying that he discovered the fountain of youth (at least a legal version of it) in the off season.
And if you've ever invested in stocks, you know that you're likely to make the same mistake the Yankees are about to make.
Rationally, your decision on whether to keep an investment in your portfolio should be based on whether that investment is cheap or expensive, given its price and value today, and not on what you originally paid for the investment or its value then ... However, we are human and almost by definition, we are not rational, and behavioral finance chronicles the costs that we bear. In particular, there is significant evidence that investors sell winners too early and hold on to losing stocks much too long , using a mixture of rationalization and denial to to justify doing so. Shefrin and Statman coined this the "disposition effect" and Terrence O'Dean looked at the trading records of 10,000 investors in the 1980s to conclude that this irrationality cost them, on average, about 4.4% in annual returns. Behavioral economists attribute the disposition effect to a variety of factors including over confidence (that your original analysis was right and the market is wrong), mental accounting (a paper loss is less painful than a realized loss) and lack of self control (where you abandon rules that you set for yourself).
In his post, Damodaran offers tips on how investors can deal with the "disposition effect."
Read more at Professor Damodaran's blog.
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