Stick to the right facts rather than emotion to choose your winners

Every year, fans fill out their brackets for March’s mad dash to the collegiate basketball championship, trying to predict winners.

For fans that want an edge, ESPN has published the College Basketball Power Index (BPI), a measure of team strength that is meant to be the best predictor of performance. This is similar to the logical system that Las Vegas uses to set betting odds – and we know who usually ends up on the winning side of those.

Even fans who fancy themselves die-hard statisticians can suffer from cloudy judgement, though.  School ties or love of the hometown team can lead to emotional picks rather than a bracket based on facts. That same kind of distraction from a well laid-out plan can cause investors to get disoriented, making it less likely that they’ll stick to the data that serves them long term.

Whether you’re a bracket or portfolio builder, there is a 100-year-old mathematical principle designed to help you make better long-term choices and avoid the costs of making emotional decisions.

The conventional wisdom

Many people assume performance data, like championship wins or semifinal appearances of college basketball teams, conforms to a bell-shaped curve. A bell curve represents a normal distribution, where performance among the population tends toward average results with a low chance of extreme outcomes.

Statisticians love a normal distribution because it simplifies the world and makes mathematical computations relatively easy and clean. Humans do too, because normal distributions reinforce our bias to underestimate the possibility of negative outcomes.

A non-normal world

Looking deeper, however, the bell curve loses its luster. In competitive areas like sports, outcomes rarely conform to this normal distribution.

Instead, we commonly observe a Pareto distribution (also known as the 80/20 rule) where 80% of the results are derived from 20% of the population. Instead of performance tending toward an average, it leans toward the extremes, with a small minority dramatically outperforming the average. Studies have shown the Pareto distribution to exist across a diverse range of human endeavors — including sports, politics, entertainment and wealth.

Consider the following distribution of performance across the 300 most successful Division I basketball teams. We measured the number of times a given team progressed to the semifinals each year, going back to the tournament’s inception in 1939.*

Portfolio

Portfolio

As you can see, the distribution is rather abnormal — the top 25% of teams dominate the league. Of the 300 potential appearances since the tournament’s inception, just over 25% of top-performing teams ever made it to the semifinals. Although a love of your alma mater might make you think the New Mexico State Aggies or West Virginia Mountaineers will take it all, ESPN’s BPI data puts perennial performer UNC at the top of the pack. This wouldn’t surprise Pareto Principle bracket builders since both teams are nearly perennial competitors in the tournament.

As a Wichita State grad, I want to ignore the math and root for the Shockers. But if you’re paying me to make the most logical bet, I have to go with Kansas, North Carolina, Duke and Arizona.

Stocks and sports – reflections of the same reality

Similar to championship sports teams, stock market winners tend to follow to a similar model.

In fact, stock market returns almost exactly mirror the distribution of performance of collegiate basketball championship teams. Longboard’s proprietary research showed that, from 1983 – 2007, among the largest 3,000 U.S. stocks, the top 25% captured all of the market’s upside.

We call this result The Competition Gap, which we explore more fully in our signature research. We believe in this distribution so much that we’ve built our business around it.

Finance, much like college basketball, is often characterized by these extreme performances. They share another feature: discipline. In order to win the basketball championship, you have to fill your team with star players and continuously prune the underperformers to keep the performance drag from ruining your run to the top.

Dan Grossmann, Ross Hendricks and Stephen Scott contributed to this article.

*We ranked the top 300 college basketball teams based on total franchise wins for our initial sample size. We then determined the percentage of those teams that were responsible for appearances in the semifinals in each year’s March tournament.

Article by Longboard Funds