Investing Lessons and March Madness

By David B. Armstrong, CFA | Mar 24, 2017 | Invest My Wealth, Weekly Market Commentary

Oh boy…March Madness. It started last week and it’s what everyone seems to be talking about at work.

Most people feel great on “Selection Sunday”, which is when the NCAA selection committee announces “The Bracket”. The bracket is the group of 64 teams (okay, I know it’s technically 68, but I’m asking for some artistic license for the sake of brevity) who will be playing in this year’s NCAA College Basketball Tournament.

The tournament is a single elimination format. Lose and you cruise…no second chances here. Each team must leave it on the floor each and every game or they will be watching the rest on TV.

When a person fills out a bracket, they simply need to pick the teams who will win each game.

Simple, right?

Yeah – every year, I’m convinced I’ve got the right bracket because the selection committee uses a seeding system for each team.

They tell me who is most likely to win.

Our friends at Dorsey Wright & Associates explain the process very well below:

The seeding process of teams began in 1979 as a way for the NCAA to make sure that the strongest teams didn’t end up meeting each other too early in the tournament, which would be a threat to TV ratings and the overall fan experience. The seeding also provides the uninitiated in basketball a basis for which to make decisions; because while there are few who have likely followed the seasons of all 64 teams from around the country, everyone intuitively understands that picking a number 16 seed (the lowest ranked teams) to beat a number 1 seed (the highest ranked) is not statistically a good bet. In fact, there has never been a number 16 seed to beat a number 1 seed in the history of the tournament. A team with a high ranking is, after all, the stronger team based upon qualitative and quantitative evaluation. They often possess more talent and better coaching than the lower-ranked teams. While past performance has certainly not guaranteed future success for all of the high-seeded teams, it certainly points the average NCAA bracket in the right direction.

Emphasis, mine.

So just by looking at the seedings, you can tell which teams have the highest probability of winning and going all the way to the end.

Turns out, the seeding process has resulted in what the NCAA intended – the higher ranked teams advance through the tournament, where excitement culminates with highly skilled and successful teams playing each other late in the tournament.

64 teams play down to 32. Then 32 play to result in the Sweet 16. From there, it gets whittled down to the Elite 8…to the Final 4, to the Championship game where only one team emerges victorious.

Like Russell Crow in The Gladiator… “ARE YOU NOT ENTERTAINED!!!???”

One thing to realize is that while top-seeded teams don’t always make it to the Final Four, historically they win about 80% of the games they play. As you recall from the Dorsey Wright quote above, a #16 seed has never won a game (thus never moving past the first round).

Here are some more interesting stats from Dorsey…

• The top 1-3 seeded teams combine for a record of 966 wins and 357 losses, a winning percentage of 73.04%.
• By contrast, the bottom 3 seeded teams (14-16 seeds) have a combined win total of just 32 games (or 7.69% of their contests) in 32 years of NCAA tourney history.
• The top 5 seeded teams have produced a winning percentage of 68.13%, while the bottom 5 seeds have won just 17% of their games.
• Top seeded teams have won more games in tournament history than the bottom 3 seeds have played (429 to 416).
• The National title has been won by a team with a #4 seed or higher in 29 out of the 32 years.

But then every year we see some “Cinderella team” or outlier emerge along the way…some low-seeded team that somehow, beyond all expectations, beats a higher seeded team.

In fact, in 2016, two #12 seeded teams (Yale and Little Rock) beat their #5 seeded match-ups (Baylor and Purdue) ON THE FIRST DAY! We also saw Syracuse, who was a #10 seed, make it all the way to the Final Four! The other three teams in the Final Four were a #1 seed and two #2 seeds.

BEAR WITH ME – I’M GOING SOMEWHERE WITH THIS…

Picking the Final Four and the ultimate winner is way more important in the grand scheme of winning your bracket than picking an early upset. A ton of time is spent trying to pick the #15 seeds that will win in the first round, when the fact is that over the history of the tournament, a #15 has only ever won 8 games out of 1024 played in the first round.

Of the 8 that make it to the second round, guess how many #15 seeds have won a second game?

One. Yup…one. So, there are 9 total wins by a #15 seed in the history of the tournament.

Taking this a step further, let’s say you predict that tenth win for a #15 seed. That creates a problem because you are also predicting the elimination of a #2 seed that wins 94% of its 1st round games (because #15 seed plays the #2 seed in the first round) …and you are also eliminating a seed that wins roughly 71% of all its NCAA tournament games.

The #2 seed has a much higher probability of making it much further into the tournament, which means people who incorrectly pick a #15 seed over a #2 seed will not only get a loss for that game, but probably a loss of two, three, or more games in their bracket.

Okay, great…so you get to brag about your guessing skills at the office for a day or two if you pick a #15 correctly. But that pick is only correct 6% of the time in NCAA Tournament history.

I think those are crappy odds. But people love to play them because they LOVE TO BE RIGHT.

There is a great quote from Peter Bernstein from an interview with Jason Zweig in a CNN Money article back in 2004. Peter, who passed away in 2009, was a well-regarded financial historian who wrote a ton of books but I think he is most well-known for Against the Gods, The Remarkable Story of Risk. In the interview he said:

The riskiest moment is when you’re right. That’s when you’re in the most trouble, because you tend to overstay the good decisions. So, in many ways, it’s better not to be so right. That’s what diversification is for. It’s an explicit recognition of ignorance. And I view diversification not only as a survival strategy but as an aggressive strategy, because the next windfall might come from a surprising place. I want to make sure I’m exposed to it. Somebody once said that if you’re comfortable with everything you own, you’re not diversified.

Emphasis, mine.

So pick the highest seeded teams…right?

Except Villanova, who won 2016 and was a #1 seed this year, but was knocked out in the second round by #8 Wisconsin. Duke, a #2 seed was knocked out in the second round by a #7 South Carolina (GO GAMECOCKS) and #2 Louisville was also knocked out.

So Where Does That Leave You – The Investor?

A few thoughts:

1. Put yourself in the best position to win long-term. Long-term investing is not about picking the perfect investments, because that is as impossible as picking a perfect NCAA Bracket (Odds 1/9,223,372,036,852,775,808 – yes that is a real number, I almost had to use scientific notation). Instead, BE RIGHT THE MOST YOU CAN. Top seeded teams win 80% of their games. If you kept track of your bracket picks for 20-30 years and picked the highest seeded teams, you’d do well. No strategy works every time.
2. Past Performance is no guarantee of future performance. It’s a standard compliance disclosure mandated by the SEC on most anything you get or see about investments. Just ask Villanova.
3. CNBC is like having March Madness 365 days a year. It’s okay to watch it, I do. But what I glean from it is general information and news…not securities selection. Try not to get too wrapped up in it. Remember, control what you can – taxes, behavior, trading, fees and diversification.

As always, our message is to have a plan and know what the money’s for. From there, make sure your investment strategy aligns with your plan and then have a long-term outlook on your portfolios.

Call with questions.

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