The March Madness of Stock Picking
Executive Summary
Creating a bracket for March Madness is an American pastime. Each year millions of brackets are created using different strategies. The end result is that most brackets do not do well even though nearly everyone is confident in their choices beforehand. The stock market is similar for investors who believe they can picks stocks better than others. The best investment firms in the world make a profit from a little more than 50% of their investments. For young lawyers trying to pick stocks and day trade, it is unlikely to go well. Research has found that few investors ever succeed at stock picking. Instead, of trying to pick the perfect bracket/stock, it’s better for investors to pick as many as possible. By choosing a diversity of picks, investors and bracket pickers have a better chance of choosing the big winners.
The end of March means the beginning of the madness of college basketball. Every year the NCAA hosts a 68-team tournament to decide who is the best basketball team in college sports. March Madness, the tournament name, is filled with moments of unbridled joy and heartbreaking losses for the players. Fans can also participate by creating a bracket that they believe will correctly guess how the tournament will go. They can then challenge their friends, family, and the sports world to outperform them. For fans who fill out a March Madness bracket, they feel the emotions of each game of the tournament.
Building a bracket each March is an annual American tradition similar to cooking a turkey for Thanksgiving. It’s an opportunity to prove to your friends, family, and the nation that you are better than everyone else when it comes to college basketball. Everyone has a strategy for picking teams. Some people spend hours digging through the fundamentals of each basketball team to determine the most likely winner. Others base their picks on which mascot they like more or which team is the higher seed in the tournament. Everyone has a different strategy, and everyone feels like they’ve picked the perfect bracket.
Until tip-off
Overconfidence bias
People have a natural tendency to overestimate their abilities. The average person thinks they are an above-average driver, have an above-average work ethic, and are better looking than the average person. Surveys have found roughly 90% of Americans think they are better than average drivers. Did you laugh at that finding? I know I did the first time I saw it. Only 50% of drivers can be above average, yet nearly everyone thinks they are better than average.
It’s a bias that affects so many decisions in our lives beyond picking the perfect March Madness bracket or investing. Every year, people create millions of these brackets that they believe will be perfect. Still, no one has ever had a perfectly chosen one where they correctly guessed all 63 games. And we might never see one since the odds of guessing the perfect bracket exceeds 1 in 9 quintillions!
The Pursuit of the Perfect Bracket
Picking the perfect bracket is nearly impossible, even creating one close to perfect is difficult. Every year the NCAA analyzes millions of submissions to see how people do. They award points to each bracket based on whether a game was guessed correctly or not. Guessing a game correctly in the 1st round only counts for 1 point. Each round’s point value increases proportionately to account for the difficulty of making the correct choice with each passing round. Guessing the champion is worth 32 points. In total, a perfect bracket would score 192 points.
Do you know what the average score was in 2018?
The average score was 57, less than 30% of the total possible points. The NCAA found that the average person guessed roughly 66% of games correctly. The majority of the correctly guessed games were in the early rounds. The early games have the widest difference in talent and are not affected by “bracket busting.” Bracket busting is when you pick a team to win multiple rounds, and they lose early on. If a team is chosen to win the entire tournament but loses in the first round, a bracket loses roughly 33% of its total possible points.
These findings highlight a few principles that hold true in bracketology and investing:
You can successfully pick teams/stocks that do well in the short term and still underperform if you miss out on big winners.
Committing heavily to one team or stock leaves you susceptible to big losses. A stock/team can be a favorite now and lose soon after. It is uncommon, but low-ranked basketball teams and new companies have beat out well-regarded basketball teams and companies to the surprise of many.
You can have more knowledge than most others and still lose due to bad luck. Sometimes a bracket built by picking teams based on their mascot or choosing stocks because your aunt likes their products can outperform everyone. Skill and knowledge are not why they do better. Instead, luck substantially affects performance for March Madness and the stock picking.
How to pick the perfect bracket/portfolio
The march madness bracket consists of 68 teams playing 63 games over a few weeks. The tournament is a collection of shocking moments and predictable victories. As shown above, it is nearly impossible to pick a perfect bracket. Even an average submission captures roughly 30-50% of the total value available in the game. Yet people continue to create them each year with supreme confidence in their abilities and strategy.
The stock market is similar and different to picking teams in a March Madness bracket. First, the stock market has investors who think they know something other people don’t know. Many investors watch trends, identify fundamentals for success, and listen to the experts to get all the information they need to make the best investment decisions. They use these possible insights to pick stocks to invest in with the hope of receiving above-average results. The result is similar to making brackets for March Madness. Some people do have above-average returns, but most people fail to even come close to a perfect investing strategy.
The financial industry has more investment resources than any investor could reasonably need in a lifetime, yet no one has solved the market. One of the greatest investors in the world, Jim Simons, has an investment firm called Renaissance Technologies. It is arguably the best-performing investment firm in history. They have access to some of the brightest minds in finance, better data than their competitors, and computing power that likely performs hundreds of trillions of calculations per second, yet the firm only profits on slightly more than 50% of their trades.
If the best investment firm struggles to pick investments correctly better than 50%, how can regular investors do better? There have been numerous studies to answer this question, and the results are unsurprising yet staggering.
Ben Carlson’s blog A Wealth of Common Sense laid out a few of the studies that looked into day trading and found:
A study of Brazilian futures traders found 97% of individuals who traded in the market for more than 300 days lost money on their trades.
Research on individual day traders in Taiwan from 1992 to 2006 showed even the most experienced day traders lose money, and traders who lose consistently continue to trade despite their losses.
The SEC studied the habits of retail FX traders and discovered, “approximately 70% of customers lose money every quarter and on average 100% of a retail customer’s investment is lost in less than 12 months.”
A study of eToro day-traders found nearly 80% of them lost money over 12 months, with a median loss of 36%.
Similar to the performance of people picking their March Madness bracket, people also struggle to correctly pick individual investments.
Stock picking and making a bracket are also different. Each year, fans select winners from 68 teams over 63 games. At most, a team will play in 7 games. The format is simple, but it creates countless possible outcomes. Investing has exponentially more outcomes to consider.
As of 2019, there are over 41,000 public companies. Each public company offers stocks to buy and sell at any time, unlike a bracket that you set and forget. Buying and selling essentially double the decisions an investor has to get right. No one wants to buy high and then sell low.
Investing is also over a longer time frame than the tournament. Investing is not limited to 7 days of trading. Investors can buy or sell stocks 253 days a year, every year for the rest of their lives.
Is it worth filling out a bracket or investing then?
Knowing what you know now, would you invest your life savings on your bracket being the best bracket?
Probably not.
Would you invest your life savings on it doing better than your friends and family? (Remember overconfidence bias.)
It is okay if you say no. This blog post is not about discouraging you from investing or submitting a bracket. Instead, it is supposed to highlight our limitations. Being a successful day trader and picking stocks for a career appeals to many people. You may have even heard of stories of people making life-changing wealth by day trading. These stories lead people to believe they can also start day trading even when the odds are against them.
The list of successful day traders is small. The list of failed stock pickers is a mile long.
Instead of day trading and picking stocks, evidence suggests that it is not about choosing the right company or team. Instead, investors can find success by acknowledging their limitations and diversifying their picks to give themselves the best chance for long-term success.
So how should investors think about investing?
In March Madness, there is always a winner. At the end of the tournament, one team rises above the other 67 teams to win the national championship. If you chose that team, you likely beat your friends and family. What if you played a bracket tournament where you could create multiple brackets with different winners? Do you think your chances of choosing the winner would improve?
Of course!
Now, what if you could pick more than that? 4 brackets? 16 brackets? Enough to create every possible outcome? Do you think your chances of guessing the winner would keep improving?
Yes!
If one of your teams lost early in the tournament, but you made a bracket that also chose the surprise winner, would your bracket be busted?
No! One of your brackets would still be correct.
We all know there will be a winner, and there will be a lot of losers. Diversifying your picks to include different winners, which may be improbable but can happen, allows us to have a better chance of winning overall. If you pick an unlikely winner and they end up winning, it does not matter how the other brackets did over the other 62 games. Winning at the end separates the best brackets from the average brackets.
How does diversity apply to stocks?
Instead of betting on one team or stock to outperform, give yourself as many opportunities as possible to benefit. Diversity increases the chances of succeeding by increasing the chances of picking winners. Morgan Housel, the author of The Psychology of Money, noted that the Russell 3000, which is an index that tries to capture the performance of the US stock market over time, is nearly 75 times larger than it was 34 years ago. He also notes that 40% of the companies in the index have gone bankrupt or out of business. It seems impossible for something to become 75 times larger while 40% of the companies lose almost all their value. The craziest part is the growth of the index was primarily because of just 7% of the companies in the index.
When you only pick one stock to invest in, you have a higher chance of picking the 40% of companies that fail instead of the 7% of companies that are wild successes. If you choose a diversity of stocks, plus your focus is on the long-term rather than the short-term, you are less susceptible to the ups and downs of a single company. Similar to the tournament, there will be winners in the stock market. Diversifying instead of hoping for one specific outcome is the best way to benefit from the luck and randomness of March Madness and the stock market.
Investing is a necessary part of anyone’s financial life. It does involve risk, but if done correctly, lawyers are likely to see a growth in their investments over the long term. But investing can be challenging for lawyers. Lawyers are particularly busy professionals. Finding time to sort through all of the investment options and deciding which ones make the most sense can be time-consuming. Additionally, lawyers may not have confidence in their investment strategy. To help these lawyers, the Developing Financial Process offers investment management as a component of the overall planning process. The investment strategy is custom-built by identifying diverse investments that align with each person’s unique goals, time horizon, and risk tolerance. This saves lawyers time to focus on other things while also giving them a strategy they can feel confident in. If you would like to learn more about investment management and its role in the Developing Financial Process, schedule a free Meet & Confer. This 30-minute meeting is an opportunity to talk with a financial planning professional about investing and its potential risks and benefits for young lawyers.
Disclaimer: Nothing in this blog should be considered financial advice or recommendations. Your questions are unique to you and your own personal financial circumstances. You should consult with a financial professional before making a financial decision. See full blog disclaimer.