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What Bracketology Teaches Us About Banking

Are Successful Financiers Simply Luckier Than Their Competitors?

A dozen years ago, my wife filled out an NCAA bracket on a popular website.  Out of more than 1 million entries, she finished somewhere around 17th. 

Think about it: 17th out of a million.  Clearly I married up!  I mean everyone says their spouse is one in a million, but how many really mean it? 

So how impressed should any of us be by my wife’s bracketology success?  And what does her success tell us about the brilliance of this year’s top investment managers? 

Let’s be honest.  Most years, in most offices, the winning NCAA bracket comes from someone who is far from an expert on college basketball.  In fact, it almost has to be that way.  Knowledgeable people do not pick VCU to make it to the final four, or Lehigh to beat Duke.  By the end of this year’s NCAA tournament, the person with the top ranking bracket in the country will have to have picked several early round upsets.  And picking upsets is mainly a function of luck, not skill. 

Not to say that expertise doesn’t matter.  Consider the people who set up the tournament.  Look how often the one or two seeds end up in the final four.  Those folks know what they are doing.  But if you fill out your bracket at the beginning of the tournament, and choose the favorite in each game—which is the strategy that these experts have, in effect, done—you will never, repeat never, come out as the top bracket. 

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Coming out on top requires foolish judgments combined with good luck. 

People know this.  That’s why you don’t see people with last year’s top brackets being recruited away from their jobs as painters or secretaries, and brought into jobs to work as sports analysts.  We celebrate these people’s accomplishments, and revel in their good fortune.  But we don’t make the mistake of attributing their success to brilliance or insight. 

Why then are we so quick to attribute investment success to the brilliance of whatever hedge fund manager, or Goldman Sachs trader, achieves this year’s best returns? 

Whomever the number one trader will be this year at [insert your favorite investment bank here], that person will have had to make some stupidly risky decisions.  Being smart and savvy might earn great returns over the course of a long career, assuming that being so smart and savvy doesn’t cause a person to get fired.  But in any given year, picking stocks is a lot like picking NCAA underdogs.  The smart money is almost always on the obvious choice.  The number 2 seed should beat 15.  But to stand out from your peers, to be number one at Goldman Sachs or number 17 on the ESPN bracketology site, you must make some dangerous picks. 

In investment banking, bonuses are given out each year based on an individual investor’s returns on their investments.  These wildly lucky people are handsomely rewarded for taking risks.  That in itself is a problem, because it is our money that these people are often putting at risk.  But to make matters much worse, most people in the Goldman Sachs office mistakenly believe that those high earners did something worthy of merit, something that reflects their intelligent investing style. And they are impervious to more logical explanations. When Dick Thaler and Danny Kahneman (two of the founders of the field of behavioral economics) showed investment firms data confirming that their top earners were the recipients of good old fashioned luck, the bankers scoffed at their analyses.

Perhaps Thaler and Kahneman should have reminded the bankers about the NCAA tournament. Because people don’t make the mistake of thinking that office bracket winners won without a lot of luck.  March Madness has much to teach us about the madness of financial markets.  Keep that in mind the next time you decide whether to trust your life savings to last year’s top rated investor.  Ask yourself whether you want your hard earned money invested with someone who has performed the financial equivalent of picking Lehigh over Duke. 

 

**Previously posted on Forbes**

Peter Ubel, M.D., author of Critical Decisions and Free Market Madness, is a physician, behavioral scientist, and Professor of Business and Public Policy at Duke University.

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