Schaeffer's Trading Floor Blog

March Madness: A Lesson in Trading and Bracketology

The differences between trading and filling out NCAA brackets

by 3/27/2014 7:19 AM
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So, how did your brackets work out? It seems so obvious how it's all going to play out … until the games actually start. Roger Pielke Jr. on the new FiveThirtyEight site has a piece entitled When Picking a Bracket, It's Easier to Be Accurate Than Skillful.

Incorrect NCAA predictions come from two places: One is the failure to anticipate upsets, and the other is the prediction of upsets that don't occur. Because favorites win most games, the upsets you get wrong are far more important than those you get right.

In fact, after the first weekend of play, it turns out that 83.4 percent of entrants in the ESPN Bracket Challenge would have been better off picking all the favorites.

Okay, sounds somewhat intuitive. I mean, there's always a "Mercer Beats Duke" type upset or three, but favorites win most of the time. As they do in regular-season games, too. I'm pretty sure if you adjusted for the fact that these are by and large neutral-site games (Oregon, who played Wisconsin in Milwaukee might disagree), there's as many upsets in tournament form as there are in any random games.

But how can we tie this knowledge to our investment decisions?

In forecasting, accuracy isn't enough. Being a good forecaster means anticipating the future better than if you had just relied on a naive prediction. It's difficult in more consequential settings than the NCAA tournament as well. For example, investing in a mutual fund with a portfolio that mirrors the Standard & Poor's 500 Index over the past decade would have generated better returns than 65 percent of managed funds overseen by investment professionals. Think about that: 65 percent of mutual funds charge fees to underperform an investment strategy that requires no thinking and lower fees.

And here's where he loses me. I use sports analogies as much as anyone … in fact, I'm using one right now. But this comparison makes no sense. The goal of an investor is to generate returns. There's a very good case for an individual to index, namely the difficulty in outperformance that he accurately notes. And probably understates. Many will try to sell you on their ability to generate "alpha" on top of your returns, and many can and do deliver. Many will try to accomplish that themselves, including everyone that trades actively. And that's all fine and good, but it's purely a personal risk/reward decision that everyone makes.

And again, market returns are a perfectly acceptable outcome.

The goal of "accuracy" in forecasting a 68-team tournament is completely different. You're not attempting to get a "market" result. No pool pays you money if you finish in the top 20th percentile. You are attempting to beat what he calls the "naïve" model by as much as possible. You're not the investor, you're the fund manager here. Except that you're the fund manager with no downside. In real money, you can take insane risk, but you'll most likely lose and either have no cash or no investors left. In a bracket pool, you'd just come in last or, more accurately, "not winning money," which again, is the only theoretical goal (if it's for pride, you're not winning that either).

That's not to say you should just roll the dice and pick all upsets -- you very much shouldn't. Tip: load up on under-seeded teams that are small underdogs or even favorites over higher-seeded teams (11th-seeded Tennessee was a 6-point favorite over 6th-seeded UMass, Iowa would have been favored also had they beaten Tennessee in the play-in, et al.). Remember, all you're trying to do is generate "alpha" with your picks.

And, that's really the point. Alpha is great in investing, but it's risky, difficult to achieve, and not required. Market returns are often desirable. It's great to be "skillful," as he defines it, but it's not required. In bracketology, however, alpha is the only goal, and the construct of risk -- as far as investing goes -- has no meaning. You will only win your pool if you're either "skillful" or a bit lucky in a small sample size of games.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.


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