“Bracketology”, a term coined by ESPN, is the study of the annual NCAA college basketball tournament. Interestingly the art or science of filling out an NCAA tournament bracket also provides insight into how investors select investment assets. Before explaining, we present you with a question: When filling out an NCAA bracket do you A) start by picking the expected national champion and work backward or B) analyze each matchup, and pick winners starting at the earliest rounds, working toward the championship game?
In A, one has a pre-determined idea for which team is the best in the country and disregards the path that team must take to become champions.
Those using B’s methodology look at each game and consider the participants, compare their respective records, their strengths of schedule, demonstrated strengths and weaknesses, record against common opponents and even how travel and geography could affect performance. In a methodical, rigorous evaluation, the result is a conclusion about which team can win 6 consecutive games and become the national champion.
Outcome vs Process
Outcome-based investors start with an expected outcome, typically based on prior results, and select assets accordingly. How many times do we hear the gurus of Wall Street preach that stocks return 7% on average and therefore a well-diversified portfolio should expect the same thing this year? Many investors take the bait and few question the rather simple approach that drives the expected outcome and ultimately the investment selection process.
Process-based investing, on the other hand, is a tactic to better determine how assets should perform. The method may be based on macroeconomic expectations, technical analysis or a bottom-up assessment of individual companies to name a few. Process investors do not just assume that yesterday’s winners will be tomorrow’s winners nor do they diversify just for the sake of diversification. They create a procedure to help them forecast which assets are likely to provide the best risk/reward prospects and deploy capital opportunistically.
