Opinion and Investing Column

KIM: Don't be fooled by 'hot hand' fantasy in hoops or investing

December 8, 2012

KimThe familiar sounds of bouncing balls and squeaking sneakers announce the official arrival of Hoosier Hysteria in gyms throughout our state. With basketball a metaphor for life for many passionate fans, what lessons hold true both on and off the court?

University of Chicago finance professor Tobias Moskowitz and Sports Illustrated writer L. Jon Wertheim teamed to pen “Scorecasting: The Hidden Influences Behind How Sports are Played and Games Are Won.”

When they met at summer camp in 1984, they were just a couple of sports-crazed 12-year-olds: Toby from Bloomington and Jon from West Lafayette. Twenty-five years later, their book challenges sports truisms that most fans accept as articles of faith.

According to the authors, “momentum is such a vital component of sports that it’s taken on the qualities of a tangible object. Teams and athletes have it. They own it. They ride it. They take it into halftime, into the series, into the postseason. They try like hell not to give it back or lose it.”

However, while streaks surely occur in sports, rigorous statistical analysis does not support the existence of momentum. While they might look and feel the same, momentum implies that the most recent outcomes (good or bad) have some predictive power for immediate future outcomes. They simply don’t.

Momentum is probably most often cited in basketball. Players, coaches and fans “know” you should “feed the hot hand.” Shooters run hot and cold. The result of the previous shot is a great predictor of whether the next shot swishes the net or clanks off the back of the rim. If a player makes a couple of shots in a row, you just keep feeding her the ball, baby.

The authors explained why fans attribute so much importance to momentum in sports, when it’s mostly fiction. People like patterns and need to be able to explain events. Randomness and luck resist explanation and make us uncomfortable. Further, most of us don’t grasp the laws of chance.

Investors, too, often “chase the hot hand” by flocking to funds with the best recent performance and fleeing funds that have lagged. The authors point out that just like a “hot hand” in sports, one quarter or one year of good performance has little predictive power. In fact, one year of performance for almost any fund is dominated by luck, not skill.

Constantly chasing the hot investment hand can be extremely damaging to your long-term returns.

Stick with a manager with excellent long-term (10 years-plus) performance whose strategy makes sense to you. Understand that short-term underperformance is inevitable and you will endure difficult periods.

Davis Advisors published a study showing that, for managers ranked in the top 25 percent for the 10-year period ending Dec. 31, 2011, 96 percent had one three-year period that placed them in the bottom half, 68 percent had one period in the bottom quarter, and 35 percent had one period in the bottom 10 percent.

Lay-ups and free throws aren’t flashy, but they win basketball games. Similarly, a slow-and-steady strategy is boring, but it wins the long-term investment race.•

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Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC, an investment adviser based in Columbus, Ind. He can be reached at (812) 376-9444 or mickey@kirrmar.com.

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