March Madness For Investors
Outcome versus Process Strategies
It is that time of year when the markets play second fiddle to debates about which twelve seed could be this year’s Cinderella in the NCAA basketball tournament. For college basketball fans, this particular time of year has been dubbed March Madness. The widespread popularity of the NCAA tournament is not just about the games, the schools, and the players, but just as importantly, it is about the brackets. Brackets refer to the office pools based upon correctly predicting the 67 tournament games. Having the most points in a pool garners office bragging rights and, in many cases, your colleague’s cash.
Interestingly the art, science, and guessing involved in filling out a tournament bracket provides insight into how investors select assets and structure portfolios. Before explaining, answer the following question:
When filling out a tournament bracket do you:
A) Start by picking the expected national champion and then go back and fill out the individual games and rounds to meet that expectation?
B) Analyze each opening round matchup, picking winners and advance round by round until you reach the championship game?
If you chose answer A, you fill out your pool based on a fixed notion for which team is the best in the country. In doing so, you disregard the potential path, no matter how hard, that team must take to become champions.
If you went with the second answer, B, you compare each potential matchup, analyze each team’s respective records, strengths of schedule, demonstrated strengths and weaknesses, record against common opponents and even how travel and geography might affect performance. While we may have exaggerated the amount of research you conduct a bit, such a methodical game by game evaluation is repeated over and over again until a conclusion is reached about which team can win six consecutive games and become the national champion.
Outcome Based Strategies
Outcome-based investment strategies start with an expected result, typically based on recent trends or historical averages. Investors following this strategy presume that such trends or averages, be they economic, earnings, prices or a host of other factors, will continue to occur as they have in the past. How many times have you heard Wall Street “gurus” preach that stocks historically return 7%, and therefore a well-diversified portfolio should expect the same thing this year? Rarely do they mention corporate and economic fundamentals or valuations. Many investors blindly take the bait and fail to question the assumptions that drive the investment selection process.