By Ryan and Mike O’Donnell
Key Takeaways
· As with investing, past performance does not guarantee future success in the NCAA basketball tournament.
· Whether investing or filling out brackets, don’t let confirmation bias, recency bias or emotion cloud your thinking
· You must take on some risk to be successful. The key is knowing how much risk you can tolerate and still sleep well at night.
Even if you’re not a big college basketball fan, it’s hard to ignore the annual NCAA men’s basketball tournament, a.k.a. March Madness. It’s on TV around the clock from St. Patrick’s Day through early April. Office productivity comes to a standstill as millions of people who couldn’t find Murray State, Weber State or Valparaiso University on a map, are frantically checking their “brackets” every time there’s a score alert about their games.
I find the whole pursuit of March Madness brackets fascinating because it reminds me so much of the behavioral finance mistakes people make when investing. Here are some of the most obvious missteps I see:
1. Recency bias. Time and time again investors follow the herd chasing after a “hot” stock that everyone’s talking about. Remember the early days of the pandemic, when Peloton, NetFlix, Zoom, Etsy and other stay-at-home plays were the darlings of Wall Street? Today those names have mostly given back their gains and fallen below their pre-pandemic levels. Same goes for the initial March Madness tournament favorites. Gonzaga and Arizona dominated their opponents throughout the season and in their post-season conference tournaments, running up a combined 61-8 record. Vegas oddsmakers and the NCAA tournament committee anointed those hot teams as the two most likely teams to make it to the finals and millions of “bracketeers” dutifully penciled them into their championship game bracket. Oops!
But both teams went down early in the tournament while Duke and North Carolina made it to the Final Four. While Duke and Carolina have won 12 national championships between them and are loaded with future NBA players, neither had won the title since 2015 and 2017, respectively. Further, they both lost plenty of games in the final week of the regular season and came up short in their post-season conference tournament. So the word on the Street was that they belonged in the tournament, but were not expected to hoist any championship banners this year. According to NCAA.com, only 17% of brackets had Duke to make the Final Four and only 3% of brackets had North Carolina to make it that far. So, most people ignored Duke and Carolina in their brackets and will have to watch Vivian from accounting -- who knows nothing about sports -- celebrate winning the office pool.
2. Familiarity bias. During March Madness, people are more likely to pick their alma mater or a team from their geographic area to do well even if their record and roster of talent would suggest otherwise. This bias worked out for people in North Jersey and alums of St. Peter’s (the first #15 seed ever to make the Elite Eight), but eventually even the Peacocks came back to earth after getting blown out by perennial contender North Carolina. Same goes for investing, when people disproportionately invest in their own industry or companies close to home because they think they know those stocks so well. Familiarity basis is sometimes combined with overconfidence bias, because when you think you know more than the market, chances are you don’t.
3. Confirmation bias. In March Madness, people spend hours scouring the newsfeeds, Vegas odds and expert tweets about their favorite teams. What they’re looking for is for a well-known pundit to confirm that a team they like will go far in the tournament. It doesn’t matter if most oddsmakers, ranking services and the tournament committee don’t agree. If they have just one source of information supporting their gut instinct, they believe it’s a sure thing and put their money behind that decision. Same goes for investors who turn to the Jim Cramer’s of the world on TV to recommend a stock or a sector that they’ve already bought into for whatever reason – even if they haven’t done their homework. Most of the time confirmation bias results in busted brackets (and portfolios). Don’t succumb to this one.
4. A winning formula is not persistent. Just like no stock (or fund) continues to top the charts year after year, there have been only six repeat winners in the 80 year history of the NCAA tournament and only two in the past 30-plus years (Florida 2006-07 and Duke 1991-92). In investing, the fund manager, sector or asset class topping the charts one year is often a laggard the next year (see Callan chart below).
5. Succumbing to emotion. Just like 75% of active managers can’t beat the market in any given year, you can March Madness pool by taking the passive (unmanaged) approach of simply betting the favorites (i.e., the higher seeded teams). Using that strategy is not fun, but you’d outperform 75% of other bracketeers nationwide. It’s just like investing in an unmanaged index fund or ETF. There are no decisions to make and no personal biases to overcome.
6. Not diversifying enough. While playing the large cap favorites will keep you near the top of your office pool, you must take some risks on small cap and value stock “underdogs” to win your pool. The key is to select a few small cap upstarts to defeat the large cap favorites in the early rounds. Those early bonus points for picking upsets will carry you far even if a few of your big names stumble in the later rounds. Only once in the 80-plus year history of the NCAA tournament have all four #1 seeds made to the Final Four (2008) and only five times have three of the four #1 seeds made it to the Final Four. What’s more, never have all four teams in the Final Four been from the same athletic conference. Thinking you can ride into a comfortable retirement by only owning large tech stocks or only large cap U.S. stocks will only leave you with a busted portfolio and bruised ego.
Conclusion
Have fun with your brackets, but when it comes to your portfolio or retirement plan, you don’t want bias or emotion to cloud your thinking. If you or someone close to you has concerns about your investment plan or risk allocation, please don’t hesitate to reach out. We’ve helped many clients like you in similar situations.
