Investment Lesson from NCAA March Madness

March Madness is a phenomenon that grips the sports nation from early March through the first week of April. It's the National Collegiate Athletic Association (NCAA) Men's and Women's Basketball Tournaments that determine the national champions of college basketball. College basketball can actually teach us about investing.

One simple question
When I teach or give presentations, I often ask the audience a simple question:

What percentage of the time do you think the college basketball team that is behind at half time comes back to win the game?

Before reading on, take a guess. I typically get responses ranging from 30 percent to 50 percent and have had responses as high as 90 percent. This means that we think a team comes back from a halftime deficit roughly a third to half of the time. Were you in this range?

The answer
Leading the exciting life that I do, I once counted thousands of college basketball scores. The answer revealed that the team behind at halftime only comes back to win the game a little under 20 percent of the time. Thus, we tended to overestimate the odds of a comeback, forgetting the fact that the team behind at halftime was probably the same inferior team that also showed up in the second half.

There are two reasons we overestimate the odds.

Reason one - Hollywood
This is America, where the underdog always comes back. Have you ever seen a movie or TV series where the worst team in the league didn't end up winning the title in a stunning comeback? A team that starts out bad, and stays that way, just isn't a crowd pleaser.

Reason two - the news
I never seem to have time to watch the whole game so I watch the late night clips. They include many sensational comebacks, with the team behind by ten at halftime rallying to win in double overtime. We tend to see more of these types of stories because the game where the team down by ten at the half, and ultimately loses by 20 points, doesn't actually make a good highlight.

These lead us to be overly optimistic
A steady diet of all this dramatic victory gives us the perception that the comeback occurs far more often than it does. And that's because we think Hollywood and the sports news is giving us a representative sample of reality. In actuality, it's a very biased sample.

Basketball and Investing
The same phenomenon that leads us to be far too optimistic in estimating basketball comebacks also leads us to be overly optimistic in investing. We think it's possible to pick the next hot fund because we open the newspaper and see only the strong performing funds being advertised. We do this even though we know that these strong performers aren't indicative of what will perform well going forward.

Listening to the television gurus bragging about their winners, and not mentioning their losers, instills a confidence in their skill that, frankly, there is no evidence to support.

My advice
Don't count on your confidence in investing to be any better than your ability to outguess the point spreads in March Madness. Enjoy the NCAA tournament and feel free to make a wager on the winner. Just take a moment and ask yourself if you are perhaps making the same wager with your investments.

MORE ON MONEYWATCH
Money and Happiness - You Can Have Both! Gary Schilling's 2009 Predictions - What Went Wrong? The Risk of Taking a Risk Profile Questionnaire