By Ashley Bleckner, CFP®, MA
With March Madness quickly approaching, millions of people across the country are completing their tournament brackets (RS Crum included). Amid the fun, we often overlook the underworking of point spreads & brackets. While we may feel far removed from statistics class, you’re closer than you think. Point spreads are actually statistical models. While models can be useful for gaining insights that can help us make good decisions (or good bets), they simplify reality. How the model is used is equally as important as the model itself.
Experts use current and past data on players, teams, and performance to make a number of assumptions in an attempt to approximate who will be crowned champion each year. These models may help you win the grand prize; however, as anyone who has completed a bracket knows an unexpected upset can and will happen during the tournament. This is why the odds of picking a perfect March Madness bracket are 1 in 241 billion! The lesson: the world can behave differently than even the most advanced model can predict.
With investment management, models are one tool that helps us formulate our decisions. Financial researchers are frequently looking for new models to help answer questions like “What drives returns?” These models are complex in nature, commonly leading to debates about who has a “better” model. Those who evaluate investment strategies can benefit from understanding that markets cannot be fully explained by any one model. Just like with March Madness predictions, investment models rely on inputs. Instead of analyzing free throw percentages or personal fouls, investment models may look at variables like expected return or volatility. But, users should be cautious as a model’s recommendations are based on the quality of its inputs, and poor assumptions can lead to poor conclusions.
Nobel laureate Robert Merton offered some useful insights on this topic. “You’ll often hear people say, during the [financial] crisis or something, ‘There were bad models and good models.’ And someone will say, ‘Is yours a good model?’ That sounds like a good question, a reasonable question. But, actually, it isn’t really well-posed. You need a triplet: a model, the user of the model, and its application. You cannot judge a model in the abstract.”
Consider the shape of the earth. One simple model describes the earth as a round sphere. While this is a good approximation, it is not completely accurate. In reality, the earth is an imperfect oblate spheroid—fatter at the equator and more narrow at the poles than a perfect sphere. Additionally, the surface of the planet is varied and changing: there are mountains, rivers, and valleys. So how should we judge the model of “the earth is round?” For a parent teaching their child about the solar system, assuming earth is a perfect sphere is likely a fine application of the model. For a geologist studying sea levels, it is likely a poor model. The difference lies in the user of the model and its application.
With investing, one should pay similar attention to the details of user and application. For example, a well-recognized model (the Efficient Markets Hypothesis) states that market prices reflect all available information and it is therefore not possible to outguess the market. In applying this model to real-world investment solutions, there are several nuances that a user of the model must understand in order to bridge the gap between theory and practice. Even if prices quickly reflect information, rigorous attention must be paid to trading costs and to avoid trading in situations when there may be asymmetric information or illiquidity that might disadvantage investors. Most of the effort is in implementing the idea and making it work.
In the end, there is a difference between blindly following a model and using it judiciously to guide your decisions. By employing sound judgment and thoughtful implementation, we believe it is more likely that outcomes will be consistent with expectations. By selecting an investment manager that has experience in effectively putting financial research into practice and executing an approach that balances discipline with value-added implementation, investors should increase the probability of having a positive investment experience over the long term.
So who am I picking as National Champions in my bracket? One model suggested I pick Villanova to be a repeat winner, while another suggested Kansas based on their proven track record this season. But, this is March Madness and I’m not sticking to any model. I’m pulling for the Cinderellas… Go Saint Mary’s!