Most of us don’t want to talk about how our selections performed in the recently concluded NCAA men’s basketball tournament. By the second round, our brackets were a complete disaster as we failed to forecast upsets, and some of our favorite picks were upset. At the same time, we began to envy the prowess of our friends and colleagues whose brackets remained relatively intact. By the last weekend of the tournament, we were in awe of the select few who had correctly predicted the final four teams in the competition. What does all of this have to do with investing? Everything.
The three weeks of the tournament are a primer in the behavioral quirks that shape, and all too often, misshape our investment portfolios. While our retirement portfolios and educational savings are more serious matters than selecting the winner of the contest between North Dakota State and Oklahoma, we approach the exercise with the same behavioral weaknesses that draw us to a particular mutual fund or stock.
Ascribing skill to our winners and bad luck to our losers is perhaps our biggest mistake in filling out brackets and making investments. Rather than evaluate why a particular investment failed to meet our expectations, we tend to chalk it up to bad luck. If you joined me in selecting Duke to beat Mercer, our failure was just a case of ill fortune. Conversely, if you were one of the few to pick Mercer in their first round match up, you probably felt a bit smarter than the rest of us. By the time the tournament reached the semi-finals, the leaders in your office pool were probably viewed as a slightly more savvy than the folks lingering at the bottom of list. If you analyzed the data from any one of the fantasy contests, you’d discover that the difference between winning and losing brackets is actually quite small, and the winners were merely lucky.
The same can be said for portfolio managers. Losing managers tend to blame the president, the Federal Reserve, or just bad luck for their poor performance. Winning managers attribute their success to their keen insight and skill. When we hire the managers, we prefer to imbue them great intellect and talent. Isn’t it more comforting to think that your portfolio manager is a master of his domain, rather than to admit he has relatively little control over the performance of your portfolio?
The NCAA tournament brings out another important weakness in most of us as investors: overconfidence. Whether you prefer to listen to the sports experts on ESPN or the financial gurus on CNBC, you’ll be treated to an extreme display of overconfidence. Syracuse was a lock to beat Dayton, and Tesla Motors or some other stock is certain to soar. Whether it’s the experts or mere mortals, we’re far too certain about our predictions.
As human beings we’re apt to prefer stories to analysis. The NCAA tournament always has to have a Cinderella. Investing is no different. Whether its money managers or stockbrokers, they’re skilled at weaving a compelling tale that emphasizes clever stock selection and exciting companies over meaningful analysis. We also approach filling out our brackets and investing with a number of preconceived notions. I’m sure that a large proportion of UNC fans, as well as Connecticut alums, had their teams going deep into the tournament. Their respective choices weren’t based on any analysis. However, in the end those who penciled in Connecticut looked awfully prescient. In investing, we fall back on all sorts of preconceived notions about companies, security prices, and money managers. Rarely do we test those assumptions. Let’s be honest, analysis is boring and hard.
Stories over analysis
For many of you, the 64-team NCAA bracket creates an overwhelming number of decisions. While you wanted to participate in Warren Buffett’s billion-dollar challenge or the office pool, making all the selections was daunting. At the outset, you might have done a little bit of analysis about the teams, but after awhile, you either abandoned the effort or just randomly selected teams. It turns out that poorly constructed 401(k) plans create the same problem for investors. Faced with dozens of possible investment choices, many employees either default to the “one-over-n” heuristic or simply fail to select any options because the task is overwhelming. The one-over-n heuristic means that an investor puts a little of his money in every available option.
Those of us who thought the Warren Buffett billion-dollar challenge was free were fooled by our preference for stories over analysis. While you didn’t have to plunk down any cash to participate, Quicken Loans required you to provide all sorts of valuable demographic information in order to make a bet that had somewhere between a one in 128 billion and one in 9 quintillion chance of paying off. By the middle of the first round of the tournament, not one of the 15 million entrants had a perfect bracket anymore. Quicken Loans had a wealth of information and free publicity, and Mr. Buffet had pocketed millions of dollars in insurance premiums for making an extremely prudent bet.
Mr. Buffett’s challenge helps to point out one enormous difference between the NCAA Tournament and investing, and it has to do with our assessment of risk. In filling out the brackets and putting ten or twenty dollars into the office pool, we were engaging in risk-seeking behavior. Even though we were more than likely to lose our entire investment, we were still willing to wager small amounts of money. The lottery is another example of risk-seeking behavior, because analysis tells you that you will almost certainly lose your money. Risk-seeking only gets us in trouble when we start to gamble with large sums. Fortunately, most of us confine this kind of behavior to small bets. Every so often at least a few of us succumb to risk-seeking behavior at the casino or stock market (some of you may not see much of a difference between the two), and we get in a lot of trouble.
While the rational investor described in finance textbooks should be risk averse, most of us have an aversion to losing money. Rather than trying to minimize risk for a given return, we tend to want to guard against loss even though the odds of an actual loss are relatively remote. In other words when it comes to investing large sums of money, we’re too concerned with losing money, rather than managing our risk. For example, as long-term investors trying to fund a child’s education or our eventual retirement, we should look beyond the periodic declines in the financial markets. However, the wiring in our brains makes us overly fearful of these unpleasant episodes. Moreover, we tend to overestimate their frequency. As a result, loss aversion leads us to hold too much cash or sell out of risky assets like stocks at precisely the wrong time.
Each March, millions of us succumb to a bit of basketball madness. Despite our incredibly busy lives, we find time to make our selections and then spend hours watching 63 basketball games. Imagine if we carved out just a fraction of that time to analyze our portfolios and financial advisers. We’d probably be better investors but wouldn’t have nearly as much fun.
Andrew Silton’s Meditations on Money columns can be found twice a month in The N&O’s Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/