A Capital Asset Pricing Model (CAPM) is traditionally used in the world of finance, but I believe it can be applied to baseball. While I think it could apply to all parts of an MLB organization, I believe the model is best suited for international scouting/signings and the coinciding player development.
Why International?
Unlike the MLB Draft, there is a much more free and open market for international amateur players (for now). What I mean by that is teams can sign any player they like for any amount of money, up to their max amount of pool money, in the international space. In the draft, teams have to wait and see who is available at their respective turn in the draft, with each pick and player’s associated “risk” fluctuating every pick. The international market of players is much more efficient in terms of player valuation because a player can sign for his market value and a CAPM is all about efficiency.
What is a CAPM?
In finance, a CAPM helps investors determine the required return for a potential investment for a given level of risk. Different investors have different levels of risk preference, but an investor will always prefer an investment with the highest expected return for a given level of risk. For example, if Investment A presents an expected return of 10% and Investment B has an expected return of 9%, an investor would choose Investment A if the level of risk is the same.
If an investment in financial terms is a stock, or portfolio of stocks, that investment in baseball is a player, or portfolio of players. How are the two any different? An organization (the investor) wants to sign (invest in) the player(s) that present the highest expected return for the level of risk they are taking on.
CAPM Components
A CAPM has a few components. The formula in finance is:
Expected Return = Risk-Free Rate + Beta(Market Return – Risk-Free Rate)
Integration of Player Development with Scouting
In order for this to have a chance to work, there will need to be a strong emphasis on integrating player development with scouting. The aforementioned Beta and Market Return will be based on previous performance history of players in the farm system. This would require organizations to track player performance, which could be done through something like Driveline TRAQ, and/or something similar to the coach evaluation system I previously posted about.
An individual player’s Beta will be determined by different development programs that players are on, which is why there is such a need for a player progression tracking system. Initially, historical returns of players in a system will be used as the “Market Return,” to help find the Beta of an individual player. Using written evaluations, season stats and "practice stats" (Trackman, Blast), teams can approximate a player’s actual performance on the scouting scale regardless of whether they are still playing, have been released or they retired. The difference between all players’ peak actual grades and their initial present grade (when they were drafted or signed as an amateur) will be the Market Return, AKA “Farm System Return.”
A Beta of 1 would mean the player is progressing at the same rate as the system. I think of this as the traditional model of training where nearly every player is on the same development plan. A player with a Beta of 1.1 would be seen as 10% more volatile than the system, possibly for being on a velocity development program that carries some additional risk, or just in general has varying returns for many reasons. If the system is progressing in a positive direction, that would mean the player with a Beta of 1.1 is progressing at a rate of 10% more than the system. A player whose Beta is below 1, such as .5, would mean he is progressing with 50% less volatility than the system. This type of player would likely be one who is injured or on rehab that is not progressing at the same rate, or maybe a top pick who an organization is taking a conservative approach with.
On the scouting side, an amateur prospect will be graded out per usual. However, this is another area where there needs to be significant overlap between scouting and player development…a scout will add to his report (if it’s not already something they do) recommendations for a development plan. For example, “Pitch Design,” “Velocity Development,” “Bat Speed Program,” “Traditional,” etc. That prospect is then assigned a Beta, determined by the historical volatility of players that have been on the same, or similar development plan. This could still work with scouts who are skeptical or unwilling to conform. If they write “curveball shape needs improvement,” that can be translated into a player needing to be on a pitch design plan.
Below is a set of five hypothetical development plans. To make myself clear, these are just examples, there are way more plans than just five and the grades could be completely off base. I made up fifteen players (A thru O) whose initial present grades are the same across the board. Ideally, this would be done for every player in the system. Note: The grades represent their entire player profile, not just how they stack up in terms of velocity, bat speed, etc.
The initial present grade also reflects that players’ valuation when he enters into the system. The peak actual grade is based on a combination of in-game and practice metrics that he has reached in his career. This may be difficult at the minor league level, but someone smarter than me could figure out how to normalize minor league stats to reflect that players’ actual scout grade. At the bottom of the table, the return is found by subtracting the initial present grade from the peak actual grade, and dividing by the initial grade. Those values are then averaged out to get the “Market Return,” or “Farm System Return,” in this application.
In the CAPM formula, the Risk-Free return would be 11% because that is the historically average return on players following the “Traditional” development plan, one that I view as riskless. The other plans have varying hypothetical returns. And remember, Beta is a measurement of volatility and risk. Anything with a Beta greater than 1 means we expect those players to progress at a faster rate than the traditional development plan and the opposite with a Beta less than 1, such as a rehabber.
So, what exactly does this mean in terms of an individual amateur prospect? As I stated before, a scout would write up his normal report, while taking different elements of player development into account. If a scout recommends a Velo Program, that player would be assigned a Beta of 1.2. If a scout recommends a player follow the Traditional path, the player is assigned a Beta of 1.
The chart below shows what it would take for an organization to sign a player, and perhaps choosing to sign one over another. I used just fifteen amateur prospects, but this would be done with all prospects an organization is considering signing. Each line represents the traditional development rate of two separate organizations, starting at MLB replacement level of a 40-grade player and ending at their future grade based on historical development returns. The orange organization has a lower development rate and they should sign any player who is above their line (Security Market Line in finance terms). The red organization has a better track record of developing players, so they have a steeper slope and should only sign the players on or above their line. So while the orange organization should sign prospects G and H, the red organization would be better off allocating their resources elsewhere.
Say the orange organization can only sign one player, but both prospects under consideration have the same future grade. In this case, they are deciding between prospect F and prospect G. Both players meet the criteria for being above their line. But with the same future grade that is adjusted for after their recommended development plan, an organization would be better off signing prospect F because he carries less associated risk than prospect G, the one with the higher Beta. Another way to look at this is prospect F having a higher and better Sharpe Ratio, which is risk to reward.
Considerations
Having gone through all of that, there is so much more to take into consideration. A CAPM is designed to lower risk, and I believe that the opposite actually needs to take place for many prospects. For players currently in the system that are not projected to make the MLB, I believe their risk/volatility should be maximized because there is really nothing to lose (ok, maybe from an organization’s standpoint there is something to lose such as taking resources away from the better players or surgery and rehab costs if the player is injured). But generally, I think those players with low future grades should be put on a volatile development program to create some value.
All of my numbers have been hypotheticals, so it’s highly probable that the development plans have very different returns and Beta values.
Players are more than plots on a chart. I’d like to think that I am not naïve to the point where I believe we can automatically expect players to develop at a certain rate by being on a particular development plan. And I also understand that many players are on a mixture of development practices, not just one cut and dry plan like I have outlined. It would also be difficult to say that just because a player improved his bat speed, his future grade increases by a certain amount. These are things that would need to be a conversation in an organization as to how historical returns are found, and how expected returns can be predicted.
It’s also possible that giving players a “Peak Actual Grade” is impossible, but I do think there are ways around that, if that is an issue. There could also be problems with initial present grades having inherent deviation, meaning that I think most amateur prospects, especially on the international side, are getting 20’s and 30’s as present grades in part because they are so young. Diminishing returns for prospects would also need to be considered. A pitcher who has already been on a velo program may see less gains than a pitcher who has never even heard of a velo program.
It’s possible that this model can be used to determine both the amount of money that should be allocated to a player, in addition to whether a team should sign one top prospect or multiple mid-tier prospects by utilizing the efficient frontier and Sharpe Ratio. I have not yet figured out how to do this.
Lastly (that I can think of off the top of my head), there are many components of risk that I did not factor for. Risk factors such as age, medical history, percent allocation of pool money, etc. Those should be accounted for in some way, possibly more driven by the human element after evaluating based on the historical development returns I used to define risk.
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