Tale of the (Ticker) Tape: March Madness & Investing
As we enter the second week of what’s affectionately known as March Madness, it’s a good time to reflect on what makes college basketball’s win-or-go-home tournament so “mad.” But before I dive into the behavioral aspects, here’s the math:
With 63 games played in total, the odds of picking the “perfect” bracket is 1 in 9.2 quintillion (2^63).
Even trying to correctly pick all “Final Four” teams is daunting; with 16 teams in each of the four “regions,” there’s more than 65,000 possible Final Four combinations (16^4).
As many readers are already aware, Memphis did not beat Gonzaga in the Round of 32. However, I had picked that upset, and was excited about it; the upset would separate my bracket from the pack since most people had the Zags making it out of the second round and many have them winning it all. I also have personal aversions to picking both teams. As a UCLA alum, I still remember the Memphis team (led by Derek Rose) that dashed my Bruins hopes in 2008’s NCAA Final Four. Gonzaga is the team that ousted my Bruins last year in one of the greatest NCAA basketball games of all time. So, why do any of us take the time to predict these types of upsets, let alone fill out the entire 64-team bracket? Why do our emotions so often come into play, and how influential are they in making these and other—more important—decisions?
The behavioral biases that cause us to ignore overwhelming odds and fill out March Madness brackets with confidence are innate. They’re also the same traits that lead to seemingly illogical investment decisions. The subconscious influences that lead us to buy and hold investments are the same that make us cheer on underdogs, and root for teams that we may have never paid attention to in the past.
We can name more than a few heuristics and cognitive biases, but two important ones are the Affect Heuristic and the Illusion of Validity.
Heuristics are the "shortcuts" humans use to reduce task complexity in judgment and choice, and biases are the resulting gaps between normative behavior and the heuristically determined behavior (Kahneman et al., 1982)
The Affect Heuristic
Rather than wasting time to objectively assess a situation, we tend to make decisions quickly if they also feel good. During March Madness, picking your alma mater feels good, even if they may be an underdog and have a statistically low chance of advancing., When we make decisions, including buying investments that make us feel good (e.g., ESG), or even if we’re just in a good mood, we tend to overestimate the upside, and simultaneously underestimate the risks. Similarly, when we review options that may have been presented negatively, or if we’re in a bad mood at the time, we tend to underestimate the potential return and overestimate the risk. Particularly when making quick decisions, it’s very difficult to avoid these mental shortcuts. It’s not necessarily a bad thing to go with your “gut,” especially if it means you can root for your favorite teams or pick upsets few others saw coming. However, when it comes to investing, it’s important to avoid making rash decisions by allocating sufficient time to logically evaluate options.
The Illusion of Validity
Confidence is not an indicator of more accurate predictions. So why do we—after spending time and effort to research the field of competitors—become disproportionately more confident with our March Madness brackets relative to our odds of success? The Illusion of Validity is driven by a few underlying biases and heuristics, namely confirmation bias and the representativeness heuristic. Confirmation bias is our tendency to search through data in a way that validates pre-existing beliefs. In other words, when filling out a bracket with a winner already in mind, we’re more likely to focus on the information that best fits that trajectory. The representativeness heuristic is a mental shortcut that influences decisions based on stereotypes or preconceived notions. Sticking with March Madness, we tend to favor the “blue blood” schools (UCLA, Duke, Indiana, Kansas, Kentucky, and North Carolina) because they are well recognized and have won the most championships. With respect to investing, “past performance is not indicative of future returns” is a well-known, and required, disclaimer. Yet investments, just like March Madness picks, are made with such confidence because we tend to immediately anchor to historical data that’s not only familiar but also supports our initial decisions (while also diminishing, or ignoring, any conflicting data). Representativeness also leads us to seek out patterns and trends over random events. It causes investors to “ride the hot hand” and overweight an investment or asset class that is outperforming.
Building Diversified, Well-Researched Portfolios with a Trusted Advisor
At SineCera Capital, we take the principles of behavioral finance to heart. While it may not stop us from rooting for our alma mater during March Madness, it’s important to remember that the same behaviors that lead to irrational exuberance as sports fans are equally prevalent in investing. The challenge with overcoming these behavioral biases and heuristics is that we often don’t realize that they are influencing our decision until it’s brought to our attention by someone else.
When it comes to investing, the key to avoiding some of these traps is to invest in a well-diversified portfolio consisting of uncorrelated and negatively correlated assets. That means when some investments are up in the portfolio, others may be down. Easier said than done when we’re wired to go all-in on top performers and sell “losers.” But, by regularly rebalancing a diversified portfolio, we believe investors can achieve better risk-adjusted returns and have better odds at avoiding unpredictable outcomes. Further, when dealing with investments where you have limited knowledge or familiarity, it’s easy to let emotions guide your decision. Providing comprehensive due diligence on alternative investments is one of our core services and we think it helps our clients make objective decisions without letting the emotional tail wag the rational dog.
As fiduciaries, it’s paramount that we help our clients navigate through these challenges by having thoughtful conversations, doing the proper due diligence, and guiding them towards the best decisions for their families’ wealth.
If you have any questions, or would like to learn more about how SineCera Capital strives to help our clients, please do not hesitate to contact us.
Best Regards,
Adam J. Packer, CFA®, CAIA®
Chief Investment Officer | SineCera Capital