Wild point swings. Last-minute rallies. Falls from glory. This March has seen them all. Just when you think you know what’s going to happen, something comes out of nowhere and shakes up everything.
When UC and Xavier lost back-to-back games a couple Sundays ba – wait. Did you think I was talking about the market? I guess that’s fair since this is a finance blog. I was planning to spend this blog bemoaning Cincinnati’s double defeat in the NCAA men’s basketball tournament, but I guess now that you mention it, this March has shown us there are some striking parallels between the tournament on the court and the one in the market. Let’s talk about that instead!
Everyone has a System
If you’ve ever participated in a bracket game, you know that everyone has their own system for deciding who they advance to the end of the tournament. Some people choose the top-seeded teams, others go for the upset, some base it on EPSN commentary and others pick teams whose colors or mascot they like. Many of us fill out a bracket for fun, but we all know someone who thinks they’ve cracked the code for selecting future winners. They toil over the data until they are sure they’ve got it just right. They take off Thursday and Friday and wait for their genius to be revealed. Sadly for them, nobody has ever been able to come up with a way to accurately predict what’s going to happen when 64 teams face off. Do we think Warren Buffet would offer up $1 million dollars for a perfect bracket every year if there was even a reasonable chance someone could do it?
Active investment management is no different. Every stock picker has a system they think offers insight into what companies are going to be the winners and losers in the market. Some use price-to-earnings ratios, others prefer book ratio or dividend track record. Some look at the performance over the last 52 weeks, or the company’s reputation in recent news. Whatever factors they use, they feel confident that their mix of data – the same data that is available to everyone – is the key to outperforming the rest of the market. They are convinced that the one, two or ten large U.S. companies they choose will consistently beat the S&P 500.
As it turns out, they’re not much better at doing that than we are at filling out our brackets. In a study that spanned a 15-year period, mutual funds managed this way only outperformed the S&P 500 8% of the time. It makes you feel better for not picking Loyola-Chicago, doesn’t it?
Nobody is Safe
One of the reasons it’s so hard to choose winners and losers is that even the ‘safe’ bets often don’t pan out, for reasons no one could see coming.
Two weeks ago, few thought the University of Maryland, Baltimore County was going to defeat number one seed Virginia. A sixteen seed had never defeated a number one and Virginia was the overall favorite to win the tournament. Nevertheless, UMBC dominated Virginia and beat them by nearly 20 points. Only 3.4% of people who completed ESPN brackets called that one.
Just as Virginia was expected to dominate the tournament, there are companies many expect will dominate the future economy. Amazon, Facebook and Google come to mind. Their ubiquity in our daily lives makes it hard to imagine that these behemoths are just as vulnerable to unpredictability as any other business. That notion of impenetrability seemed to be holding true for Facebook, as the company stock price remained steady despite the concern over their involvement in the 2016 election. Then came March, and with it news that 50 million Facebook user’s data had been accessed by Cambridge Analytica. In a matter of a day, the stock price dropped by $20 per share and the hashtag #deletefacebook was trending.
You can’t protect yourself from a data breach or an oil spill or a public relations crisis by owning a few ‘safe’ stocks. What you can do is limit your exposure to these events by owning small slices of many different companies.
Consider the Stakes
You might have found me yelling at the TV sometime during March Madness, as if it really mattered who won the Texas Tech, Steven F. Austin game. At the end of the day, it doesn’t. Sure, we might lose our bracket pool and with it a little money and pride but overall, the stakes are pretty low.
The choices we make about how to invest our money carry a lot more weight. We shouldn’t approach them with the same gambling mentality. The people who talk at the water cooler, the analysts on money programs and the active investment managers present with a lot of confidence in their ability to foresee slam dunks. The very best of them have only done better than the market 8% of the time. Those odds might be enough to pick an upset in the second round, but they definitely aren’t good enough for me to risk my entire life savings. I’ll take market returns every single time.