March Madness

The NCAA basketball tournament (otherwise known as March Madness) tipped-off last week beginning three weeks of basketball frenzy that some have compared to a national holiday.  It’s certainly one of the best sporting events of the year, but it’s more than that.  Some studies have shown that when March Madness arrives, there is a huge productivity loss across America as many workers get caught up in the excitement.

Like millions of people, I fill out my tournament bracket each year. I’m fairly knowledgeable about college basketball, yet I have never won a tournament pool. In fact, I’ve almost given up expecting great results, because I’m convinced that predicting the winners of 67 college basketball games is a triumph of hope over experience. In that regard, it’s a lot like picking winning stocks.

Have you ever noticed that experts like Dick Vitale and Digger Phelps are no more adept at picking the winners in the NCAA tournament than the talking heads on CNBC are at picking the best stocks? There are just too many variables to forecast either with any consistency. On average, we know that the higher seeded teams (best teams) will do better than the lower seeds (weaker teams), but there will always be teams like Florida Golf Coast that pull the stunning upset, busting brackets in the process. Although counterintuitive, the so-called basketball experts don’t do any better than the average guy on the street.

Trying to beat the stock market is just as futile because stock prices follow what’s known as a random walk, in that knowing previous price movements won’t help you predict the future results. Information is disseminated so efficiently, that it’s almost impossible to gain a competitive edge over other investors. You’ve probably heard about the chimpanzee beating the experts by throwing darts to select stocks. This is not too far-fetched, as passive-index funds consistently thrash actively-managed mutual funds over any extended period of time.

Someone in your tournament pool will collect the first place prize and be hailed as a basketball guru. Even so, just like the rock star fund managers from the 1990’s, it’s likely to be a different person at the top each year. Bill Miller of the Legg Mason Value Trust Fund became an exception beating the S&P 500 Index for 15 consecutive years ending in 2005. This prompted many people to wonder how much of his performance was luck and how much was skill. The question was answered, at least in my mind, when Miller’s fund under-performed in five of the next six years leaving him near the very bottom of his peer group during that time.

With thousands of mutual funds, some investors will have a hot streak, just like the guy in the office next door who wins the tournament pool by picking the Cinderella team that advanced to the Final Four.

If you want to see your name near the top of the office pool, a good strategy would be to select the highest-seeded teams across the board. The downside is that this approach also guarantees that you won’t land in first place. Random variation will undoubtedly make someone else the champion – possibly someone who made their picks based on the coolest mascots.

Similarly, if you want a sure-fire way to beat most other investors, just use index mutual funds. You probably won’t be the top investment performer in any given period, but you will never be too far from the top. Time and again index funds earn three and four-star ratings from Morningstar, yet rarely get the top five-star rating. More importantly, they are rarely awarded anything less than three stars. With investing there is not just one winner. Consistently strong performance leads to tremendous long-term gains, which makes using index funds a great strategy.

At tourney time, beware of the guy who submits more than one bracket and brags about his clairvoyant picks. Projecting both Louisville and Duke to win the Midwest Regional won’t win any awards for conviction, but it will greatly increase the chance of being correct. It’s sort of like the mutual fund companies who constantly launch new mutual funds. If one gets hot (i.e. lucky) the company can boast about its performance and star rating for the next few years and enjoy a flood of new contributions from investors. However, if the new fund flames out, it will just close or merge with another fund. Just like the guy with a busted tournament bracket, it will never be heard from again.

Funds that have folded don’t appear in most studies that compare actively-managed funds to index funds, resulting in a “survivorship bias”. This means that if closed funds were included in the studies, index funds would look even better by comparison. If I was king for a day, I would not allow more than one NCAA bracket per person, and I would not allow mutual funds to brag about good results, unless they were achieved over ten years or more.

Human beings have a number of psychological characteristics that make forecasting challenging – whether with basketball games or stock results. In addition to a tendency toward overconfidence, we see patterns in data when none really exist. Even if a pattern has some validity, it might be short-lived. For many years observers identified the January Effect noting that stocks did better in January than other months, especially small cap stocks. This phenomenon might have been real at one time, but it’s not likely to make investors much money now as markets adjust to such anomalies. The twelfth seed often upsets the fifth-seed in the Big Dance, but I know that if I make my bracket selections based on past information, it will surely be the year with few upsets.

Now that I’ve survived the first weekend of March Madness and my bracket has not totally imploded yet, I feel pretty good about my picks. I want to assure you, though, that if I should win my bracket, you won’t hear me bragging about it...well, maybe just a little.