Adam Archuleta became one of the most sought-after NFL free agents in 2006. Several teams were interested in the playmaking strong safety, but the Redskins won the bidding, making him the highest paid safety in history at the time. Owner Dan Snyder signed-off on giving Archuleta a 6-year $30 million contract, with $10 million guaranteed.
To call the Archuleta signing a bust would be an understatement. He started only 7 games the next season and was traded to Chicago for a 6th-round draft pick the following year. Archuleta never returned to his early-career form, and washed out of the league after the 2007 season.
Although Snyder has a well-known, and well-deserved, reputation for overpaying for disappointing free agents, he's not alone. There's a phenomenon of auctions that makes overpaying for top free agent players all too common.
Consider fictional star running back Freddy Adams, a top free-agent in whom several teams are interested. Each of the teams has a hole to fill at his position. The scouts and executives of each team all have their estimations of the player's value. On a scale of 1 to 10, Team A feels he's a 7.1 in terms of future expected performance, so they offer $7.1 million per year. Team B estimates Freddy is a 6.2, and offers $6.2 million per year. Team C and Team D think he's a 4.7 and a 3.8 respectively, and make offers accordingly.
Mr. Adams is no dummy, and decides to go with the high bidder, Team A.
At this point we can't know Freddy's true value, which will be revealed only after he plays out his contract. But as long as the teams' scouts, coaches, and executives have any degree of competence, we know where his actual value would tend to be. Each team has its own biases and errors, and some will overestimate while some will underestimate his value. It's very likely Freddy's true value will lie somewhere between the high and low estimates.
Let's say that over the course of his contract, Freddy's true value turns out to be 6.2. Since Team A offered $7.1 million per year, and he was 'truly' worth only $6.2 million per year, Freddy was a disappointment on net, worth -$0.9 million per year.
This result was bound to happen. The team that most grossly overestimates a free agent's value will very likely be the team that offers the most and win the auction. The upshot is that free agents tend to be signed by the teams that erred the most in predicting their true worth. That's why free agent signings turn out so disappointing so often.
Known as The Winner's Curse, this phenomenon is a well-documented characteristic of auction-style transactions. Whether the object of the auction is a part of the wireless frequency spectrum, licenses to drill for oil, or securing the rights to a Pro Bowl-caliber safety, the top bidder will likely be the one who most overestimates the value of the prize.
In truth, the Winner's Curse applies strictly to "common value" auctions, where the prize would be of equal value to all bidders. This is rarely the case in reality, so to account for differing values to bidders, we can add a "synergy" factor to the mix. A player might be of particularly high worth to a team with a single 'missing piece', or a speedy pass-rushing linebacker might be of special value to a defense that plays a 3-4.
In the end, however, the synergy value of the prize is just as susceptible to overestimation as its common value. A free agents would be just as disappointing to his team, which would likely be the team that overestimated both the general value and the particular synergy he could bring. (Check out this applet that demonstrates the Winner's Curse in action. You'll notice that the synergy factor needs to be extremely high to escape the Curse.)
Once the top free agent is signed in any given year, the market is now 'set' for other lesser players. The Winner's Curse tends to inflate the price of similar goods across the market place, creating a bubble. The real estate or stock markets may not be so different from the free agent market in the NFL. Which home buyer is going to be the one that ends up with that McMansion? The one who overestimates its value the most, that's who. And with each inflated sale, all home prices inch up one more tiny notch, at least until a market correction comes along.
Bidders who are aware of the Curse can mitigate its effect by suppressing their bids below what they believe is the true value of the prize, a technique known as bid-shaving. This makes it less likely a bidder will end up overpaying, but it also makes it less likely the wise bidder will win the auction. The unsavvy bidder (such as Dan Snyder, perhaps) won't shave his bids, and becomes that much more likely to win (and overpay for) the prize.
Perhaps the Winner's Curse explains why top teams tend to build their starting lineups through the top rounds of the draft and not through free agency. It may also explain why draft picks might be better bargains than veteran free-agents with similar expected performance levels.