Watching Basketball Improves Investing

Net Gains: How Watching Basketball Can Improve Your Approach to Investing
March 15, 2006; Page D1
Wall Street Journal Link to Entire Article

(1) Keep your cool. - Statistically, hitting three or four shots in a row -- or beating the market in consecutive years -- just isn't that unusual. Indeed, if you and a bunch of friends each flipped a coin 20 times, half of you would likely get four heads in a row.

"Fund managers can look like they're hot or like they're a market beater," says Thomas Gilovich, co-author of the "hot hand" study and a psychology professor at Cornell University. "But you swap out of your underperforming fund and into the hot fund at your peril. Given that the market is pretty efficient, past performance just isn't a good guide."

Why do people reach grand conclusions based on skimpy data? Part of the blame lies with so-called confirmation bias. If you are convinced you're a great stock picker or that basketball players can "get hot," you will likely find the necessary proof.

"The brain looks for patterns," says Meir Statman, a finance professor at Santa Clara University in California. "And once you decide there is a pattern, you will look for confirming evidence and you will dismiss contradictory evidence as a fluke."

(2) Expecting less. - While it's hard to say definitively that some fund managers are superior to others, some basketball teams clearly are more skillful. Yet fans of weaker teams are forever hopeful.

How often does a college basketball team that's trailing at halftime come back to win? Allan Roth, a financial planner with Wealth Logic in Colorado Springs, Colo., often puts this question to audiences. He says people typically guess that between 30% and 60% of teams make a comeback.

In fact, Mr. Roth looked at over 3,300 college games played in November, December and January and found that, among teams trailing at the half, less than 20% came back to win. Why do folks think the number is so much higher? Mr. Roth figures there are two reasons.

First, we tend to be overly optimistic. "It's America," Mr. Roth says. "We believe in the underdog -- and we believe in the small investor." Even though studies suggest that most investors lag far behind the market, we like to think we can beat the odds and come out on top -- which helps explain why market-tracking index funds still aren't that popular.

Second, comeback victories tend to get the most media attention, so they stick in our minds. "It's the same thing with hot mutual funds and hot money managers," Mr. Roth says. "Because investors only hear about the winners, they think it's easy to beat the market."

(3) Playing the odds. - Investors hate the idea of losing, which can lead to irrational behavior.

Investors are often too worried about looking foolish in the short term. Stocks, like the three-point shot at the buzzer, may be the best bet. But many investors shy away from stocks, because they worry about stinging short-term losses and the pangs of regret that accompany them.

"If you believe there's a premium to owning stocks, you're crazy not to own them if you're a long-term investor," Prof. Thaler argues. "You shouldn't be so bothered by day-to-day or month-to-month volatility."