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Know the score

What sporting tactics can teach us about stockpicking
Know the score

Investors should welcome the new football seasons in England and the US, because there is a lot we can learn from sport about investing.

This sounds odd. Aren’t they very different things? No. In one respect, sport is exactly like investing. The first question an investor must ask is: how, in an uncertain world, do I divide my money between risky assets and safe ones? But sportspeople also face a choice under uncertainty between a risky and a safe option. The tennis player must choose to either return the ball into the centre of the court where she has little chance of winning the point or try hitting it to the edge of the court where she might win the point but risk losing it too. The footballer must choose between the safe pass that keeps the ball but merely maintains what Arsene Wenger called sterile possession and the pass that might create a goal but carries a greater risk of losing the ball. The batsman must choose between a defensive shot that scores no runs and an attacking one that might score a six but also get him out. And so on.

Because it is like investing, sport can teach investors a lot. One surprising thing it teaches us is that even the very best professionals go systematically wrong despite having big incentives to get things right.

This was first pointed out by David Romer at the University of California at Berkeley in 2006. He showed that NFL teams were far too conservative when they had a fourth down. They punted the ball – thereby forfeiting possession – rather than try to run or pass to get a first down. There are, concluded Professor Romer, “systematic, clear-cut, and overwhelmingly statistically significant departures from the decisions that would maximize teams’ chances of winning”.

This has been corroborated in other sports. Cliff Asness at AQR Capital Management has shown that ice hockey teams that are trailing do not replace their goalkeeper with an attacking player as much as they should. A team of Israeli economists has found that football goalkeepers would save more penalties by standing still than by diving, and yet they dive. And Devin Pope at the University of Chicago and Maurice Schweitzer at the University of Pennsylvania have shown that golfers make birdie puts less often than puts for par of comparable difficulty because they focus more on achieving par than on undershooting it.

Fierce competition and big incentives, therefore, do not lead people to maximize their chances of winning. Which suggests that conventional economics is flat wrong: contrary to the textbooks, we do not optimise.

This casts grave doubt on the idea that markets are efficient. If the best coaches and players in the world miss chances of winning matches, isn’t it likely that investors likewise miss some underpriced shares?

It doesn’t, however, follow that stockpickers have a great chance of beating the market. This is because the same mistakes that cause sportsmen to miss winning chances or investors to miss profitable opportunities also stop us exploiting others’ errors.

One of these is the urge to do something. Goalkeepers dive when they shouldn’t because it is the done thing: they look like muppets if they just stand there. In the same way, Brad Barber and Terrance Odean, two California-based economists, have shown that investors lose money by trading too much. Sometimes it’s better to do nothing.

But why do we feel the need to act? A study of betting on top-division Italian football shows one reason. Tommaso Nannicini at Bocconi University has found that bets placed closer to kick-off lost more money than those placed earlier. This might seem odd: just before kick-off, punters know more about the line-ups and formations of teams than they did a few days earlier. Such information, however, is actually a handicap. It creates what Princeton University’s Alexander Todorov calls an “illusion of knowledge”: details that give people more confidence than predictive ability. In truth, punters are better off relying on simple heuristics – such as that Juventus are a better team than Brescia – rather than on lots of little facts that don’t help.

The same applies to stockpicking. A lot of what we know about a company is irrelevant, not least because it is already in the price, but we sometimes nevertheless act on it. “People sometimes trade on noise as if it were information,” wrote the late Fischer Black in a classic paper.

One particular way in which we trade on noise is by misunderstanding randomness. Think of a lowly ranked tennis player playing a world-class one. Is the lower-ranked player more likely to win a three-set match or a five-set one?

The answer is a three-setter. Over short periods, a poor player can beat a better one just by luck: this is why in football the league (played over 38 games) is seen as a better measure of a team’s quality than the FA Cup, in which top teams play only six matches.

But people don’t always realise this fact, as a study of betting on tennis matches by Constantinos Antoniou at Warwick Business School and Christos Mavis at Surrey Business School has shown. They’ve found that bookies offer too generous odds on the higher-ranked player in grand slam tournaments, which are played over the best of five sets. They – and gamblers – don’t sufficiently realise that quality tells over longer periods even if it doesn’t over short ones.

Again, investors make the same mistake. Andrew Clare and Nick Motson at Cass Business School have found that investors lose money because they buy unit trusts after short periods of good performance, failing to see that this can be due to dumb luck rather than to fund managers’ skill.

There’s another oddity about betting. For years, gamblers have bet too much on outsiders and not enough on favourites. You lose money less quickly by backing horses on short odds than those on long odds. And not just horses: Ulm University’s Maximilian Franke has shown that the same is true in football betting.

Again, this transfers into the investment arena. Ever since its inception in 1995, Aim shares have underperformed the All-share index. Investors have paid too much for outsiders – shares with a small chance of big returns – and not enough for ones that will get us rich slowly.

 

 

In these ways, sport and sport betting highlight how we go wrong when we invest. But what would happen if we were to correct these mistakes? Could we then make big money?

Not for long. The fate of Billy Beane – played by Brad Pitt in the film Moneyball – shows why. In 1997 he became general manager of the Oakland Athletics baseball team and used statistical methods to hire underpriced players. This led to some good results in the early 2000s. But results deteriorated thereafter as other teams with more money copied Beane’s methods. In competitive markets, an advantage doesn’t last for long. It disappears as others copy it.

The same is true in financial markets. John Cotter and Niall McGeever at the University College Dublin have shown how stock market mispricings largely disappear after they have been discovered. I fear (though cannot prove) that a similar fate might be about to befall stocks with sources of monopoly power (such as Unilever and Diageo in the UK or Apple and Facebook in the US). Having been underpriced a few years ago, these have since done very well – perhaps to the point that they are now overpriced. As MIT’s Andrew Lo has said, investment strategies wax and wane.

There is, though, an exception to this. Momentum investing – buying past winners – has paid off for years. And it has done so in sports betting too, as Yale University’s Tobias Moskowitz has shown. This matters. Duke University’s Campbell Harvey has shown that many findings in academic financial economics are fragile, and are not replicated in subsequent studies – a problem not confined to economics, as Stuart Ritchie has shown in his recent book, Science Fictions. This is not true, though, of the momentum effect. Dr Moskowitz’s finding corroborates evidence not just from stock markets but from commodity and currency markets too. This gives us confidence that the momentum effect is real and robust.

 

 

There’s something else we can learn from sport. Most sports are games of strategy: you must think about what your opponent will do and act accordingly. The same is sometimes true in investing. Before buying a stock we must ask: if this is such a good investment, why is the other fellow so keen to sell it to me?

This is especially true of newly floated shares. Jay Ritter at the University of Florida has shown that these underperform the market on average in the three years after coming to the market. One reason for this is that company owners choose to sell at the best time, and can do so because they know the business better than outside investors. In failing to appreciate this, investors pay too much for such shares. As Meir Statman at Santa Clara University says, investing is not a run in the park where you test yourself only against the environment. It is instead a race against others – and you must know when you are wearing heavy boots and your rivals running shoes.

It is not just buyers of newly floated shares, however, who suffer a winner’s curse – paying too much for an asset. Every football fan will remember his team spending millions on some terrible transfers. This doesn’t happen simply because managers are bad: even Sir Alex Ferguson, the most successful British manager, bought Massimo Taibi, Eric Djemba-Djemba and Juan Sebastian Veron.

One reason why some transfers fail is that what matters is not just the quality of the individual player but the match between him and his team. Virgil van Dijk, for example, was a great signing for Liverpool because his talents were a great match for what the team needed. Similarly, Olivier Giroud, while a limited player in himself, was a key part of France’s World Cup winning team because he brought out the best in others. By the same token, transfers fail when players are a bad match for their team.

This point applies to business. Harvard Business School’s Boris Groysberg and colleagues studied the performance of top managers who left General Electric to join other companies. They found that these companies thrived when their new bosses were a good match, but not when they weren’t – even though they had equally impressive CVs. A boss with an engineering background was a dud hire if the company needed its marketing sorting out, for example, but a good one if its production methods needed fixing.

Stockpickers should therefore worry less about the quality of management and more about the match between managers and what the role needs. Square pegs can be useful – but not if you have a round hole. 

They should also be very sceptical about takeovers. These sometimes work, when there are genuine synergies – matches – between two companies. Very often, however, the proposed synergies turn out to be elusive, and the bidder pays too much. Companies, as well as football clubs, suffer a winner’s curse.

But there’s another reason why transfers sometimes don’t work out. It’s that even experts cannot always know what they are doing. The Nobel laureate Friedrich Hayek said that information about the economy “never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess”. The screenwriter William Goldman was more succinct: “Nobody knows anything.”

This is especially true in the sense that great success is especially unpredictable. When Claudio Ranieri became Leicester City manager, nobody thought his team of misfits from lower divisions would become Premier League champions a few months later. Tom Brady was the 199th pick from his year’s selection of college players, but became the most successful quarterback of all time. Nobody watching Graham Gooch get a pair on his test debut predicted he’d become one of England’s greatest ever batsmen. And so on.

Success in business is also largely unpredictable. “Corporate growth rates are random,” concluded the late Paul Geroski in one study – a finding corroborated by Alex Coad at Waseda Business School. This is one reason why fund managers don’t beat the market, and why venture capital trusts see such variable returns: one or two big successes can make all the difference to a venture capitalist.

Why do we not sufficiently appreciate that our foresight about complex systems is so limited?

Again, sport has the answer. Results are sometimes due to plain chance. A team can win a game because its opponents hit the post several times, were not at full strength or just off form. In fact, in some sports luck might be the dominant element. The statistician Brian Burke has estimated that perhaps half of results in American football are due to luck rather than the skill of the teams. 

But we ignore this fact. “When things are going well, it’s not easy to say you’ve just been lucky” wrote Ed Smith – now chairman of England’s cricket selectors – in his book Luck. Psychologists call this the outcome bias. It’s the product of other biases such as wishful thinking – the desire to believe we can predict and control the world – and the narrative fallacy, our tendency to attach too much credence to nice stories.

In investing, this can be an expensive mistake. It causes us to buy expensive funds after short runs of good performance, to pile into some shares in the belief that we can predict growth, and to underdiversify across assets. In truth, though, the economy is like sports matches in that it is a complex, unpredictable system.

It is often said that the very greatest sportsmen, such as Roger Federer and Lionel Messi, are humble. Perhaps we investors must be the same.

 

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