Chasing Favorites [Post 16]

NCAA March Madness

March Madness - A college basketball tournament where 68 teams compete for the national championship. Since 1979 the NCAA has been awarding teams with seedings to determine the bracket. In that span, the final four teams remaining each year have been a 1, 2, or 3 seed 72.68%1 of the time – leaving little room for the remaining 4 through 16 seeds to compete.

This year however, the final four was a 4 seed, two 5 seeds, and a 9 seed. A highly unusual year where the favorites were taken out early.

Stock Picking

In the stock market, the biggest and most recognizable companies can be thought of as the 1, 2, and 3 seeds. They are often seen as the most reliable because of their size and brand recognition.

However, just like in March Madness, these favorites can underperform when you don’t expect them to. Dimensional Fund Advisors’ research suggests company performance tends to decrease after a company grows into one of the 10 largest stocks in the US.

The chart depicts the historic % of outperformance for these large stocks in relation to the market before becoming a top 10 stock and the % of underperformance to follow once reaching the top 10.2

Strictly for context and not as any prediction… Tesla is a current example of a company that recently became a top 10 US stock.

Summary

In the stock market and in March Madness, favorites can underperform when you don’t expect them to. In much the same way, underdogs can outperform but it is extremely difficult to determine which underdog that will be.

Consider looking into index funds to capture the returns of the broad market instead of playing the difficult game of selecting individual stocks. Just like a star basketball player can blow out their knee and impact their team’s performance, management within singular companies can have a large impact on the stock price through their decisions, legal actions, and more. This risk tied to individual stocks can be softened by investing in index funds instead.

1. PrintYourBrackets.com. (2022). Final Four Appearances by Seed.

https://www.printyourbrackets.com/final-four-appearances-by-seed.html

2. Dimensional Fund Advisors. (2020). Why Investors Might Think Twice About Chasing the Biggest Stocks.

https://my.dimensional.com/dfsmedia/f27f1cc5b9674653938eb84ff8006d8c/41615-source/why-investors-might-think-twice-about-chasing-the-biggest-stocks.pdf