Football, basketball, car racing hold keys to investment principles
Investing is a lot like being a professional athlete.
It often can be a contact sport.
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However, unlike the pros, great investors can use guidance from all different athletics arenas to get them to their competitive goals.
Racing: don’t rely on a single-cylinder engine
Modern engines tend to have many of the same parts: pistons, crankshafts, what have you. But a NASCAR driver would never expect a single cylinder engine to allow him to be competitive in the Indianapolis 500.
In today’s low interest rate environment, there’s only one cylinder (or factor) driving performance in most portfolios: equity risk. Creeping correlation between stocks and bonds means that today’s investors are unknowingly stuck with a one-piston engine.
Adding true diversifiers to a traditional portfolio is like adding a second piston to that engine. Rather than relying on one piston to do all the work, an engine with two pistons firing at different times is more efficient—and creates a smoother ride. This is because true diversifiers seek a different source of risk.
A hedge merely protects. A true diversifier aids with long-term compounding through diversification. In this way, it can potentially deliver increased returns.
Football: don’t forget your special teams
A star quarterback might help guide the team, but even the New England Patriots’ Tom Brady needs more than just his offense, tasked with putting points on the board, and a strong defense, tasked with keeping the amount of points the other team scores low. Special teams, tasked with a myriad of other important functions, from kickoffs to punt returns are also crucial members of a great team because they work together with other highly functioning units.
For your portfolio, think of the three parts – that all work together – this way:
- Stocks, tasked with being your portfolio’s offense, the engine for scoring performance points
- Bonds, tasked with being effective portfolio defense, as long as investors stay with bonds that have historically provided diversification against stock market moves
- Alternatives, tasked with a host of other important functions like special teams, ranging from minimizing maximum drawdown to lowering volatility and even adding to returns as well
Basketball: don’t underestimate the 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.
In competitive areas like sports, performance rarely conforms to the normal bell curve distribution many people expect.
Instead of performance tending toward an average, it leans toward the extremes, with a small minority dramatically outperforming the average. This is the Pareto distribution (also known as the 80/20 rule) where 80% of the results are derived from 20% of the population.
In fact, of the 300 potential appearances since the tournament’s inception, just over 25% of top-performing teams ever made it to the semifinals. 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.
Finance, much like college basketball, is often characterized by these extreme performances. They share another feature: discipline. In order to win, 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.
Article by Longboard Funds