Maybe “March Madness” is getting to us, but the hoopla surrounding the NCAA basketball tournament seems a lot like the hype on Wall Street. Betting on a team to win in the tournament isn’t too different from picking a stock to buy (or sell). In both cases, participants are subject to what Eugene Fama, professor at the University of Chicago Booth School of Business, refers to as a “zero sum game.” Just as two parties must take opposing sides in a basketball bet, a stock transaction requires a buyer and seller. Success for one participant means failure for the other.
Professor Fama spoke recently at the Chartered Financial Analyst Annual Conference where he discussed the mathematical implications of active manager (stock pickers) performance. He explained how active management before fees is a zero sum game. After fees and trading costs, Fama noted, “only the top 3% of managers produce a return that indicates they have sufficient skill to just cover their costs.” His conclusion? “An investor doesn’t have a prayer of picking a manager that can deliver true alpha (a winning record).”[1]
Despite this research, many investors still try to pick winners. Some will even succeed. For the few who do, the real question is was it due to luck or skill. It is easy to confuse the two. Once again, there is a basketball tournament parallel. Frequently, so-called “Cinderella” teams, improbable, low-seeded schools, defy the odds and beat a higher seeded team. It is hard to deny that luck is the culprit in predicting those victories. Research showing few active managers duplicate past successes suggests luck is responsible for many stock picks as well.
Many investors would benefit from considering whether their future success is probable or merely possible. For the NCAA basketball tournament, the thrill of possibly picking the year’s Cinderella is fine. For your life’s savings, you probably want better odds. At the risk of carrying this basketball analogy too far, a diversified portfolio is like betting on the arenas and concessions rather than the teams. You can count on a small piece of the ticket and hot dog sales no matter who is in the tournament.
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[1]Harrison, Mark.“Unapologetic After All These Years.” CFAinstitute.org. May 14, 2012.