Minyan Mailbag - Bracketology & Beating the Markets
My bracket ain't lookin pretty!
Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next column from Minyan Rodger Garfinkle with that very intent.
Filling out an NCAA bracket and playing the financial markets have a lot of common features. From a strategic sense the NCAA bracket may be far less complex; it is easier to analyze and understand than the financial markets, but lessons learned by studying a simple system can often be used to better understand complex systems. The following is my brief analysis of bracketology and how it relates to trading or investing.
The NCAA's selection committee is like the market. The committee assigns values for teams and the markets assign values for assets. Neither system is perfect, as they both have their flaws. If you can understand the flaws and weaknesses of the selection committee's process, you can fill out a bracket with a better chance of winning than a bracket based solely on the selection committee's seedings. Similarly, beating market benchmarks is a goal for most money managers, and doing this typically involves searching for values that have been overlooked by flaws and inefficiencies the market.
If you know enough about basketball, and start with the selection committee's seedings as a guide, you can probably find a handful of likely upsets, although you'll never find a sure thing. One sample way that the selection committee's process is flawed is that it uses the RPI ratings in the seeding process because it doesn't want to reward teams for running up the score. However, more accurate computer ratings systems exist (like Sagarin's Predictor) that factor in point differentials in games. The result is that the selection committee tends to overrate teams with good records, while many teams with a bunch of close losses are potential upset candidates. Many investors have their own methods, often based on fundamental or technical analysis, for digging up values that they think the market is missing. One of my favorite strategies is to short companies that are overstating their earnings with creative accounting, hoping to gain an edge in knowledge just as basketball fans hope to gain an edge in their brackets.
There is a high degree of luck in predicting the outcome of every NCAA tournament game, but the odds heavily favor the higher seeds. Over the last 13 years, number 1 seeds have never lost in the first round, only one number 2 has lost, 3s have lost 7 times and 4s have lost 11 times (about 20%). It is extremely rare that one of the bottom 6 seeds in a region genuinely has a better than 50% chance of upsetting its first round opponent. The structure of the bracket system makes predicting upsets in later rounds especially dangerous. For a 4 seed to beat a 1 seed, it likely has to get past a 13 and a 5. Meanwhile the 1 has a much higher chance of getting past a 16 and an 8. Since the 4 only has about a 50% chance of reaching the third round game in the first place, the odds of getting to the round of 8 are bad even if the 4 seed had a good chance of beating the 1 head to head. In a similar way, the odds favor the insiders and big players in the markets, just as they favor the high seeds in bracketology. Industry and company insiders know best when the fundamentals are changing, and it often pays for smaller investors to follow their lead. The system is also stacked in favor of the large brokerages that can use their analysts to hype their holdings and can manipulate the technical signals by throwing their weight around. Many traders have come to the conclusion that it often pays to bet on the side of institutions and against small speculators when it comes to options and futures bets.
We all know the old market line advising us not to mistake brains for a bull market. A similar piece of bracketology wisdom would be not to mistake brains for a winning bracket. Luck has far more to do with a winning bracket than does skill. Right now, a bracket based on straight seeds would have 42 points, and would be tied for 26th place in the Minyanville pool. However, with only 2 number 2s, and no number 1s eliminated so far, straight seeded bracket has a best possible score of 92 points, which would rate 5th. Most likely, a straight bracket would move up significantly over the final 2 weeks. The 125 human picks (if you count the Raging Apathetics) on average are far underperforming the straight bracket, just as most fund managers underperform their benchmarks. As with fund managers, it is a big mistake to assume that outperformance over a short period of time is a result of skill rather than luck. Some bad pickers are going to get lucky. Of the top 9 point getters in the Minyanville pool, to win the tournament three of them picked 2 seeded Wake Forest and one picked 3 seeded Kansas (teams that have already been eliminated). It is probably safe to assume that these picks were both unlucky and unwise, given the results so far and the difficult odds against a 2 or 3 seed winning the tournament. It's also probably safe to assume that their success in accumulating points so far is more a result of being lucky than it is of being good.
While the best bracket might have a 10% chance of winning a pool with 100 brackets, the odds still say that it is 90% likely that a worse bracket will end up being the winner, and there is a significant chance that one of the 50 worst brackets will end up winning. Over the long run, a good bracketeer will do better on average than a bad one, but winning the pool has much more to do with luck than skill. For individual investors, doing well on average, over time, should be the goal. However, for fund managers, the compensation structure and promotional value of being the highest performing fund rewards winning disproportionately, which encourages excessive risk taking. A highly leveraged hedge fund that serves solely as a counterparty to Fannie Mae's (FNM) derivative hedges might outperform most other hedge funds while interest rates remain in a narrow range, and attract many investors based on performance. However, if interest rates suddenly make a big enough move, the hedge fund could loose all of its invested capital. Similarly, a mutual fund that concentrates assets heavily into a small number of relatively small stocks might guarantee its own success by driving up the prices of its holdings while money is flowing into the fund, but once the flows reverse or fundamentals take over, the fund will probably show steep losses, as with any pyramid scheme. In the financial markets, a much closer look is required before an investor can be confident that strong past performance is the result of skill rather than luck or deception.
Filling out a bracket is done for fun to enhance the emotional component of the NCAA tournament experience, and it doesn't really matter if a person makes bad picks. Investing and trading, however, is done with real money and it is important not to let emotion guide our decisions. If we are attached to a team in the tournament, it's hard to bet against it, and I wouldn't blame anyone for picking their team to put together a string of upsets. However, loving a stock too much can be a mistake that results in significant economic damage. Taking emotion out of the equation and dealing only with useful knowledge and sound strategies improves the chance of success in both brackets and financial markets.
Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at firstname.lastname@example.org.
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