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March Madness and Investing: What’s your winning strategy?

March Madness is an exciting time of year. Fans cheer, teams compete and brackets are made. The annual NCAA tournament is thrilling for sports fans because of the uncertainty of what could happen in the tournament. For some, investing in the stock market brings the same kind of excitement. When a risky investment is made, the investor could win big, lose everything or anything in between. The investor intensely watches the stock market daily, similar to a fan engulfed in the exhilaration that March Madness brings every year.

The excitement and human rational used in the decision-making process for drawing up brackets has many comparisons to that of investing in the stock market. Some financial analysts claim that they can “pick” the right stocks that will outperform the rest of the market. This is equivalent to those sports analysts who seem knowledgeable enough to pick the right team who will win the NCAA Tournament.

Other strategies for winning the March Madness tournament involve making as many brackets as possible, with each bracket producing different outcomes. This is similar to a passive investment strategy, where the goal isn’t so much to pick specific winners and losers, but to buy the market as a whole and ride it out over the long run. John C. Bogle, founder of the Vanguard Index funds, once said, “Don’t look for the needle, buy the whole haystack.” If John C. Bogle was filling out his March Madness Bracket, he would most likely bet on all the teams to win in different brackets and sit for the long haul.

Active vs. Passive Strategies for Winning

An article in the Market Watch shows the similarities between the strategies for filling out one’s March Madness bracket. In Bryan Mear’s piece, “The real seed of every NCAA Tournament Team,” he says:

“I’d guess the majority of people selecting teams in their March Madness bracket will rely on the notion that if a team is seeded higher, they must be the superior team. However, it doesn’t always work that way. Sometimes teams are drastically under- or over-seeded with regard to their actual on-the-court prowess. If you can exploit that knowledge, you can identify which teams will provide you the most ‘value’ in your brackets and potentially pick upsets that people miss.”[1]

This idea of finding arbitrage in the way teams are ranked is similar to how many active management philosophies work. The idea is to find specific stocks that are under- or over-priced and then exploit these discrepancies to get a higher return in a client’s portfolio.

In 2014, Warren Buffet agreed to pay out $1 billion dollars to anyone who could correctly guess the winner of each of the tournament’s 63 games. What is the probability of success? 1 in over nine quintillion.[2] Why was Warren Buffet, one of the greatest investors of all time, willing to put $1 billion dollars at risk? Because he was confident that no one would be able to perfectly exploit the discrepancies in the rankings of the March Madness tournament. Even if a person did complete a perfect bracket, it would most likely be attributed to luck, unless they could replicate their process of selection year after year.

So how does this idea compare to investing in the stock market? While active asset managers aren’t necessarily trying to pick the perfect stock, they are trying to beat the market.

Nassim Nicholas Taleb, author of Fooled by Randomness said: “Toss a coin; heads and the manager will make $10,000 over the year, tails and he will lose $10,000. We run [the contest] for the first year [for 10,000 managers]. At the end of the year, we expect 5,000 managers to be up $10,000 each, and 5,000 to be down $10,000. Now we run the game a second year. Again, we can expect 2,500 managers to be up two years in a row; another year, 1,250; a fourth one, 625; a fifth, 313. We have now, simply in a fair game, 313 managers who made money for five years in a row. [And in 10 years, just 10 of the original 10,000 managers.] Out of pure luck. . . . A population entirely composed of bad managers will produce a small amount of great track records. . . . The number of managers with great track records in a given market depends far more on the number of people who started in the investment business (in place of going to dental school), rather than on their ability to produce profits.”[3]

In spite of this, some investors are turning to alternative investments in order to get a higher return. However, even alternative investments have questionable performance. The New York Times recently published an article entitled: “Endowment Sweepstakes: How Tiny Houghton College Beat Harvard.” The smallest endowments outperformed their billion-dollar-plus rivals for the second straight year. How is this happening? The article says: “Houghton got out of hedge funds and all alternative investments a year and a half ago, and moved the entire portfolio to a mix of low-cost index funds and mutual funds.”[4] If Harvard, the biggest endowment fund in the United States.[5], can’t beat the stock market year in and year out, then who can?

That said, is there nothing one can do in order to produce higher returns than the market? Is there no point in trying to predict which teams will beat others in order to win your March Madness bracket? Is the best option for an investor to simply buy indexes and give up on the idea of getting a return higher than the market?

Dimensional Fund Advisors

One particular investment manager does not believe that buying just indexes is your only option. Dimensional Fund Advisors (DFA) believes that the market is efficient and therefore does not try to find arbitrage. However, science has found there are certain “dimensions” of expected returns. To explain how their philosophy works, let’s go back to the March Madness comparison.

There are certain statistics and trends that may help us predict what is likely to occur in the future.  See the table[6] below for helpful statistics:

Number of times all four #1 seeds have made it to the Final Four 1
Number of times no #1 seeds have made it to the Final Four 3
Number of times a #1 seed has won the entire tournament 14
Lowest seed to ever win the tournament #8
Lowest seed to ever make it to the Final Four #11

Based on these tournament trends, we can use this historical information to more accurately predict what is likely to happen in future tournaments. For instance, it would be unwise to have all No. 1 seeds making it to the Final Four, as this has only happened once since the tournament first began in 1939. Likewise, you would be unwise to not have any No. 1 seed making it to the final four. One should also be careful about choosing a seed higher than No. 8 to win the whole tournament, and likewise one should be hesitant to have a seed higher than No. 11 make it to the Final Four.

DFA takes a similar approach to investing. While past performance is no guarantee of future results, historically, small cap stocks have outperformed large cap stocks, value has outperformed growth and short-term bonds have outperformed long-term bonds. By creating diversified portfolios (buying the market) and yet weighting them toward these dimensions of higher expected returns, one hopes to achieve a higher return.

As of today, DFA is sitting as the sixth-largest mutual fund company and is currently the fastest-growing mutual fund company in the world, as many investors are learning about this unique philosophy to investing in the stock market.

So when it comes to March Madness and investing, be sure to pick a strategy that you believe will give you the greatest probability of success. I personally like my chances in a strategy that studies tournament/market trends in order to predict future results, as compared to finding arbitrage or investing solely in index funds.

Leland Stanford McCullough IVLeland Stanford McCullough IV is an analyst with Knox Capital Group.

The information contained in this article is general in nature and is not legal, tax or financial advice. Investment Services offered through Knox Capital Advisors LLC. Insurance Services offered through Knox Capital Insurance LLC. Investing in equities can result in loss of principle. Past performance does not guarantee future results. In specific cases, clients should consult their legal, accounting, tax or financial advisor. This article is not intended to give advice or to represent our firm as being qualified to give advice in all areas of professional services.  This proprietary and confidential material is not an offer to sell or the solicitation of an offer to purchase an interest in any fund managed.  Any such offer or solicitation can be made only by means of a confidential private offering memorandum or prospectus which describes the details of the interest and significant risks involved.

 

[1] https://www.marketwatch.com/story/statistical-value-of-every-march-madness-team-2015-03-17

[2] https://www.investopedia.com/ask/answers/082714/what-are-odds-getting-perfect-bracket-warren-buffetts-1-billion-march-madness-bracket-challenge.asp

[3] Quote Excerpt From: John C. Bogle. “The Little Book of Common Sense Investing.” Chapter 9.

[4] https://www.nytimes.com/2017/02/09/business/college-endowment-investment-returns.html?_r=0

[5] https://www.usnews.com/education/best-colleges/the-short-list-college/articles/2016-10-04/10-universities-with-the-biggest-endowments

[6] https://www.statisticbrain.com/ncaa-tournament-march-madness-statistics/