Filling out your March Madness bracket provides insight into how investors select assets, structure portfolios, and react during volatile market periods.
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Starting last Thursday, March 17, our attention turned from stocks, oil prices, bond yields, and gold to March Madness and how well our predictions will hold up for the 67 college basketball games that will decide the next NCAA championship. For the next couple of weeks, discussions about how far Saint Peters can advance or is this finally Gonzaga’s year will take precedence over guessing what the Fed might do next.
For college basketball fans, this is March Madness. The widespread popularity of the NCAA March Madness tournament is not just about the games, schools, and players, but predictions and brackets. Brackets refer to the pools that many people participate in. Guess the most games correctly in your pool, and you earn bragging rights. You may also win your friends’ or colleagues’ cash.
Answer the following question: When filling out a March Madness bracket, do you:
1. Start by predicting the expected national champion and then work backward and fill out the individual games and rounds to meet that expectation?
2. Analyze each opening-round matchup, picking winners, and then repeat the process with your expected future round matchups until you arrive at your prediction of the champion?
How do you pick the winner?
If you chose answer 1, you fill out your pool based on a fixed notion for which team is the best. You disregard the potential path, no matter how hard, that the team must take to become the champion.
If you picked 2, you compare each potential matchup, analyze each team’s respective records, schedule strengths, demonstrated strengths and weaknesses, record against common opponents, and even how travel and geography might affect performance. I exaggerated the amount of research you conduct, but such a game-by-game evaluation picks a winner based on a team’s path to become the champion.
Outcome-based strategies
Outcome-based investment strategies start with an expected long-term return. Often expected returns are based on recent trends or historical averages. Investors following this strategy presume that such trends or averages, be they economic, earnings, prices, or other factors, will occur as they have in the past.
For instance, Wall Street “gurus” often preach that stocks return 7% historically. Therefore, they say a well-diversified portfolio should expect the same 7% return this year, next year, and onward. Rarely do corporate and economic fundamentals or valuations factor into said forecasts.
Buy and hold and other passive strategies are agnostic to valuation. They rely on the past repeating. These are outcome-based strategies.
Those strategies can appear full proof for years on end, as we have seen for the better part of the last decade. However, as seen in 2000 and 2008, dramatic losses occur when these strategies are followed blindly without considering a portfolio’s risk/return profile. Outcome-based methods break a cardinal rule of building wealth: They fail to avoid as much downside as possible in bear markets.
“The past is no guarantee of future results,” is the typical investment disclaimer. However, it is this same outcome-based methodology and logic that many investors rely upon to allocate their assets.
Process-based strategies
Process-based investment strategies establish expectations for the factors that drive asset prices and returns in the future. Such analysis can include economic forecasts, technical analysis, and a bottom-up assessment of an asset’s ability to generate cash flow.
Importantly, they continually monitor those factors driving asset prices and change their views accordingly. Unlike an NCAA bracket, they can make changes as teams advance.
Process-based investors do not assume that yesterday’s winners will be tomorrow’s winners, nor do they diversify just for the sake of diversification. These investors have a method that helps them forecast assets based on risk and reward prospects. They deploy capital opportunistically, not just based on a calendar.
At times, well-managed process-based strategies hold excess cash. Cash may impede results in bull markets, but the cash is a godsend when stocks prices are trading at substantial discounts.
These managers are not compelled to buy an asset because of its historical return.
Read the full article here by Michael Lebowitz, Advisor Perspectives.
