College basketball is in full swing, and we have all filled out our "March Madness" brackets. Will the tournament favorite, the University of Florida Gators, go all the way?
Believe it or not, I use basketball quite frequently to teach audiences critical lessons about investing. Here are three to watch for as the games progress.
First, the odds are we don't know the odds. I ask audiences the following question: In NCAA Division I basketball, what percent of the time does the team behind at half-time come back to win the game? I typically get answers between 30 and 60 percent. I've reviewed thousands of basketball games in pursuit of the answer, and the answer is just under 20 percent.
That's probably due to the fact that the team that has the lead going into the second half is the same team that built the lead earlier -- in short, it's usually the superior team. We overestimate the percentages of come-from-behind victories because there such victories are over-represented in the form of copious highlights. They make for better entertainment. The blowout games get far less coverage.
As a result, we come to perceive the coming-from-behind wins as representative of all games. They're not, of course, as confirmed by an NBA player I recently asked the same question. He immediately responded "20 percent," because he had many years of experiencing it rather than watching the sports news.
The lesson? In investing, you are likely to see mutual fund families tout their winners, not their losers. Statistically, there are just as many Morningstar dogs (one and two star rated) as stars (four and five star rated), but you'll never see an advertisement for the dogs.
Second, patterns are likely random. Don't you love it when a player on your team has a hot hand? Just pass the ball to him or her and it seems like a guaranteed bucket. But while that may seem to be true, it probably isn't. A study led by Cornell University's Thomas Gilovich, showed the "hot hand" theory to be a fallacy. More recent studies confirm there is little or no correlation, meaning that the hot player has no greater likelihood of making the shot than their long-term percentage.
In investing, even a 10-year track record constitutes a short streak. Considering there are thousands of funds, there is a mathematical certainty that some will beat the markets handsomely entirely by random luck. Even funds with a 15-year track record can suddenly tank, doing the equivalent of coming in as the No. 1 seed and losing in the first round, like Bill Miller's Legg Mason Value Trust.
Third, design matters. The top tournament seeds -- Florida, Arizona, Virginia and Wichita State, in this year's NCAA tourney -- are almost certain to have a combined winning tournament record. That's typically because they have the best athletes and coaches, in addition to first playing the lowest seeded teams in the tournament. It certainly doesn't guarantee that one of the four will win the whole tournament, but they have far better odds.
Design matters when it comes to investing as well. Low-cost broad index funds that own the entire market are the equivalent of the top seeds of the tournament. Owning the entire market at a cost of 0.05 percent annually is mathematically certain to beat investors in the market paying one or two percent.
So grab the pretzels and beer and root for your teams. But if your team is behind at halftime, your odds may not be as good as you think, and the player with the hot hand may not save the day. And if your team is playing the top seed, let's hope they beat the odds.