Hard to believe, but the annual NCAA men’s Division I basketball tournament is upon us. The national championship of college basketball (aka “March Madness”) is the ultimate three-week long reality show. Where else can little known universities (aka small cap growth stocks) such as St. Peters, Loyola of Chicago, Murray State, Weber State and Florida Gulf Coast suddenly jump into the national limelight alongside powerhouses Kentucky, Kansas, Duke, Villanova, UCLA, and North Carolina (aka the mega cap blue bloods)?

Bracketology is not an exact science

As many of you know, filling out your NCAA tournament brackets can be great for office morale, despite the drop in productivity. It’s not like picking stocks in which there are over 10,000 companies to choose from. There are only 68 teams, playing a total of 67 games. Every team’s record, roster, statistics, and injury status are out in the open. Like the markets, the Vegas oddsmaker instantaneously digest and “price in” all new information that could materially impact the outcome of each game. It’s all publicly available and free of charge.

While an estimated 20 to 30 million people painstakingly fill out their tournament picks every year, there has never been a verified perfect bracket. The closest to perfection came in 2019, when a Columbus, Ohio, resident correctly chose the winners of the first 49 games of the tournament only to see his picks unravel in the third of six rounds. For years, Warren Buffett has offered his employees a $1 billion prize for picking a perfect bracket and he’s never come close to paying out.

So why are we so bad at it?

It turns out our bracket-picking prowess gets clouded by many of the behavioral biases that derail investors: Recency Bias, Confirmation Bias, Following the Herd, Familiarity Bias, the Halo Effect and more. Filling out your brackets is like constructing a diversified investment portfolio. You’re trying to find the right balance between the “safe picks” (the top seeded, blue-chip stocks) and the “upset picks” (the undervalue lower seeds, aka small cap growth stocks) that will earn you bonus points separate you from the other players in your pool.

And that’s where the human mind gets sidetracked by our behavioral biases. Let’s look at some of the most common ones:

Recency Bias. Investors believe that last year’s top performing stocks and funds will repeat their success in the current year. In reality, last year’s top performers are usually in the middle or bottom third of the pack the following year. Remember how well tech stocks did in 2022 or how poorly energy did? What a difference a year makes.

Same goes for March Madness. Last year’s Final Four teams were all blue chip programs that appear in the tournament almost every year. Defending champion, Kansas is back and looking strong. But North Carolina and Villanova didn’t even qualify for the tournament and Duke had to win nine of its final ten gams just to break into the top 20. And what about St. Peters, the tiny (micro-cap) commuter school from Jersey City, NJ that made a Cinderella run into the Elite Eight? The Peacocks didn’t even have a winning record this year and failed to qualify for the NCAA tournament.

Familiarity Bias. It’s amazing how many people pick their alma mater to do well regardless of the team’s record or who else is in its bracket. People also tend to over-pick teams that are in their geographic area because they hear about them all the time on the news, or because many family members are alums. The reciprocal of Familiarity Bias is Unfamiliarity Bias. That’s the tendency to ignore promising investments because you’re not familiar with the company or industry. Same goes for March Madness. West Coast powerhouses UCLA and Arizona are having superb seasons, but because their games are on too late for most East Coast fans, they’re far less likely to make the Final Four in brackets filled out east of the Mississippi. Likewise, West Coast hoops fans are far more likely to overlook UConn and Marquette, even though both programs have been in the national top 10 and make it to the Big Dance almost every year.

Overconfidence Bias is another derailer for both investors and bracket players. Most pool participants have massive confidence is top-ranked teams. Yet, only once in the history of the tournament (2008) have all four No.1 seeds made it to the Final Four. Some years only one of the four No.1 seeds will make it that far—you never know which one.

Anchoring is another common fallacy known to affect millions of investors and NCAA Tournament pickers. It’s the misguided belief that “Duke or Kentucky ALWAYS get to the Final 8” or that “Kansas and Purdue NEVER win the big games” regardless of the team’s record or tournament readiness in a given year. Considering that star players often don’t stay more than one or two years at the elite programs these days, anchoring based on brand name or reputation is even more dangerous today than it was in the past.

Following the Herd. Oddsmakers love it when the American public stampedes over itself crowding into the same bets. Even though history shows all four No.1 seeds almost never make it to the Final Four in the same year, guess which teams have the majority of votes to make it to the Final Four this year: Alabama, Kansas, Purdue and Houston (the four No.1 seeds in 2023). If you’re keeping score at home, three of the four No.1 seeds (Houston, Alabama, and Purdue) have never won a national title. Hmmmn.

The “Halo Effect” comes into play when investors blindly follow the recommendations or investing choices of gurus such as Bill Gross and Warren Buffet. It’s the same when bracket pickers blindly follow the wonky statistical models of KenPom, 538, and RPI, or blindly pencil in the “sleeper” picks of their favorite TV analysts. As with the stock gurus on TV, the picks of the expert hoop heads on TV rarely pan out.

Then there’s the fallacy of “getting back to breakeven” a mental accounting trap that has plagued gamblers and investors alike for centuries. How many times have you held on to a losing stock for years, just waiting for it to get back to the original purchase price before you can convince yourself to sell it? Likewise, how many people keep selecting BYU (30 tournament appearances without a title); Missouri and Xavier (29 appearances without a title), Tennessee (25 appearances without a title); Alabama and Creighton (24 appearances without a title) to advance far in the tourney because they have a national following and win most of their regular season games each year. Then there’s Gonzaga University, formerly a little-known microcap from eastern Washington and now a mighty mega-cap. The Bulldogs have qualified for the NCAA tournament an amazing 24 straight years and have never won fewer than 23 games in a season over that span. They have an impressive 28-5 record this year and are currently seeded No.3. Just about everyone has the Zags penciled in for a deep run in the tournament despite having never won the NCAA championship. EVER.

Conclusion

Whether investing, gambling, or taking part in the friendly office pool, always check your emotions at the door. Working with an objective, independent advisor is one of the best ways we know to prevent your intuitions from causing you to stray from your plan and making costly mistakes you’ll later regret.

Who’s your pick to win it all and why? I’d love to hear from you.

#marchmadness, #behavioralfinance, #bracketsbusted