If you’re a college basketball fan, like me, March is one of the most fun times of the year.
68 teams compete for the college basketball title. Some are automatic entries by way of winning their conference tournaments, while others are chosen ‘at-large.’ It’s far from a perfect means of crowing a champion, but it is easily the most captivating means. Thursday through Sunday you can at least find a game on in the background and studies have shown that there isn’t quite as much work getting done in the office.
Now, I don’t know how you measure that exactly, but the point may be well taken that some people do spend a fair bit of time watching the games, checking the scores and their brackets, and filling out their brackets ahead of the tournament. It has taken on a life of its own, captivating the interest of even the most casual of sports fans.
Speaking of brackets, I wanted to see if I could draw a parallel to investing from the tournament – especially since you probably aren’t tuning into this to get tips on your picking the field of 68!
To be fair, when I fill out my bracket it is somewhat uninformed, since I haven’t really watched much of the regular season games and must rely on season record and past reputation. It’s usually pretty unlikely that I pick an overall winner that is less than a number 1 or 2 seed. Why? Well, of course, they must be a high seed for a reason, right?
As it turns out, there is some statistical backup for my rather simple brackets. Take a look at this. Since 1985, there have been 2,331 games played. Almost half of those games have been won by a top 3 seed (about 48% of the games). But those top teams have combined for a 73% win percentage.
If you look at the bottom three seeds (14-16), you see that they have a combined 39 wins in the tournament. A little over 8% winning percentage, never advancing past the Elite 8 (fourth round).
So if you were me (and you didn’t follow the teams during the regular season), how would you fill out your bracket? Don’t get me wrong, I love an underdog story and find myself rooting for them. And yes, many times you will see a number 12 seed beat a number 5 seed in the first round. In fact, a 12 seed beats a 5 seed over one-third of the time.
Look at those second-round games of the middle seeds (10-12). If they get past the first round, they win over 40% of their games. But in the last 26 years, no team seeded 9 or below has won a game in the Final Four, out of 7 games (in 36 years).
Transitioning to the world of investments, March can often be a crazy month as we can see a spike in the volatility index. That note aside, we have discussed how our ‘model’ works – sometimes in detail, sometimes at a very high level.
In very general terms, you can say that our model is similar to picking winners for March Madness. What? That’s not what I want to hear, right? Hold on, give me a minute.
Remember, since our model looks at relative strength (which assets are better than others), we rank asset classes from 1 to 5 in order of strongest to weakest. Not much different than seeding the different basketball teams. We rank our assets against their peers (other possible investments), but instead of relying on rankings based on human judgment (like basketball), we’re relying on data driven by empirical data.
Many people will spend lots of time analyzing those lower ranked teams, rather than focusing their efforts on those higher ranked and much more likely to win overall. Now that’s not to say that a lower ranked asset can’t outperform a higher ranked one, but over the course of time, it becomes more unlikely that that trend persists.
There was a study done by Benjamin King that looked at individual stocks and what caused them to move. He found that 80% of the risk was associated with the sector it belonged to and the overall market. Only 20% was specific to that company. Which is why most stocks tend to go up or down together.
We want to spend our time in these three areas in regards to portfolio selection:
- Rank the macro asset classes from best to worst to give us a framework
- Overweight those top two asset classes
- Find the best sectors or diversified assets within those two asset classes
It’s also one of the reasons we tend not to focus on individual stocks. Why focus on the 20% when we could focus on the 80%? That doesn't mean it’s not fun when you take a shot at one and hit a big winner, but likely the rest of the stocks in that same sector went up as well.
Of course, that’s within the bigger picture of planning (where do you want to go and how best to get there). As you know, we also do a lot of work on the psychology of investors and the market. Sometimes they are linked and other times not so much.
Nothing ruins a good plan like not being able to stick to it when things get tough.
We’ve given many examples over the years, and here’s another. How many times could Jeff Bezos have bailed on his plan to build Amazon when things got tough? Bankers wouldn’t lend him money or private equity wouldn’t invest in his business. Stock goes down by 50%+ and the talking heads on the financial networks question his path. Those are all psychological darts thrown at him. Not unlike the psychological darts that get thrown at all of us when the market is down.
With my upcoming brackets, I’m still going to try and pick a couple number 12 or 13 seeds to make it through to the 2nd round, but none of them will make it to my Final Four. Similarly, as we construct portfolios, we are going to overweight the two best macro asset classes, as that will give us the best odds of a successful outcome. Notice I didn’t say ‘guarantee.’ Instead, it’s about putting the odds in our favor. Together with then being patient and sticking to the plan, that’s the best we can do towards a successful outcome.
The conference tournaments are underway and we will see how the selection committee puts the brackets together for us to make a dent in that $14 billion productivity loss. In the meantime, we will continue to build our investment “brackets” so that we can have a framework to decide where money is best treated.
Have a good week and as usual, if something doesn’t make sense or you want clarification (or check out my bracket…so you know what not to pick!), let’s talk.