Tuesday, January 18, 2011

These Are a Few of My Favorite Things

Observation from Investing Might Help Chiefs Football

I suffered through the Chiefs playoff game last Sunday. I’ve learned my hard lessons about cold-weather-football games, and keep an array of suitable boots and clothing. We even showed up early and did a modest tailgate. I tell people that the usual Chiefs season starts with optimism, and ends with disappointment; this year was no different.

Like any long-time Chiefs fan, I’ve had plenty of years to contemplate defeat. Still, the 2010 season will be remembered as a success. The team matured faster than expected and won more games than the three prior seasons. Not more games than each of the three prior seasons, but more games than the three prior seasons’ total. It was a big step forward.

It ended in disappointment, though. They won their division, made it to the playoffs, and whiffed on the national stage. In doing so, they actually set a record for playoff losses. No other team has as dismal a playoff record as our Chiefs. For fans, it’s puzzling and frustrating and maddening, and I can’t even imagine how the Hunt family and Chiefs players feel about it. Ouch.

My expertise is investments, not football. My athletic experience is limited to summertime softball (when I was much younger), and thousands of miles as a solitary runner from our local YMCA. I couldn’t begin to tell Todd Haley or Scott Pioli about their business; they have decades of experience and expertise that I lack. Their work motivating young and very large millionaires is massively different from my work choosing investments for local clients.

But I might offer one insight into the challenges they face. It comes from the investment business and watching Chiefs football over a couple of decades and multiple coach and personnel changes. Actually, Clark Hunt and I likely share similar longevity with the Chiefs! Many fans have longevity that far exceeds the players, coaches, managers, general managers, or media folks involved with the team.

One ongoing debate is about passive versus active investing. Academics noticed that many active managers failed to outperform statistical benchmarks. The benchmarks are expressed as index returns, with the Standard & Poor’s 500™ (S&P500) and the Dow Jones Industrial Average™ (DJI) being best known. (There are dozens of indices used in investing, but – to keep it simple – let’s just focus on those two for now.)

Each index is purely statistical. For the DJI, prices are tallied for thirty stocks. It’s the same thirty stocks, day after day, and the stock prices are entered into a mathematical formula. Boom – out jumps the number we see on television. As prices change during the day, so does the formula’s resulting number. That movement – up or down – offers some insight into the overall economic performance during a specific period of time.

The S&P500 index is broader by 470 companies. Each trading day (actually each minute of each trading day) stock prices of those 500 companies are calculated using another formula. The result is similar to the Dow average, except that this measure offers a broader gauge. Five hundred companies are more representative than thirty; so many professionals deem the statistic to be more representative.

There is a point to this. Though many people try, few investors actually do better than those (or other) statistical benchmarks. In other words, a portfolio manager using considerable research and expertise often fails when trying to beat a relevant index. In fact, there’s enough statistical evidence of these failures to spawn an entire industry of index fund investors.

Simply, an index mutual fund mirrors the exact holdings in the index. An S&P500 index fund holds the same 500 stocks in the same proportions as the index. When new money flows in, or old money flows out, buys and sells merely replicate the index.

Studies show that this passive approach is very successful. Active managers, perhaps because of trading and other costs, struggle to meet or beat an index. It’s as if the statistical compilation somehow surpasses the active effort and judgment of experienced traders. The debate rages on, but, like I say, there is strong evidence to support this phenomenon.

There are also strong advocates for active investing. Some of them even boast a powerful track record to “prove” their stock-picking expertise. They are outliers on the statistical curve, and it’s possible, maybe even probable, that some of them have captured investment lightning in a bottle. It’s also possible, or probable, that market randomness bestows that record upon them. Actually, there’s no way of knowing and I don’t really care. It is what it is.

What’s this got to do with Chiefs football? None of this discounts genuine talent or advantage. There are clearly teams in the league who have created an exceptional combination of process and players. That’s a magical combination when it happens, and it typically lasts for several years. We’ve seen it with the Patriots, Colts, Steelers, Cowboys, and Forty-Niners, among others.

Regular season football is a statistical game, played by multiple teams and some 1,600 players. You can easily create statistics to define an average player, an average team, even an average season. And crunching those same numbers, you might derive a statistical index fund of football. Using this model, football is a percentage game, and you can build a successful program by understanding those statistics and using them for personnel decisions, game plans, and specific offensive or defensive plays.

Marty Schottenheimer was a master at this. He built teams and managed games by the numbers. His Chiefs were among the winningest professional football teams of all times, and nearly as boring to watch as anything. Phrased “Marty Ball” by both critics and fans, those teams were perennial division winners. Strong defense, unimaginative offense; they marched their way, year after year, up the field and into the playoffs.

Where they died. The longstanding knock on Marty is that he’d do great in the regular season, then collapse in the playoffs. In fact, those collapses represent a big part of Kansas City’s dismal playoff record. But I don’t think it’s all Marty’s fault. Not Charlie Weiss or Todd Haley, either.

The culprit is statistical. Like an index fund, a statistical compilation (“percentage football”) might beat many teams in the league. Especially in the regular season where half the teams are – have to be – statistically below average. If you choose the right players, call the right plays, get the right bounces, have a similar number of good and bad calls by the referees, you’ll win more than you lose — and take a winning record to the playoffs.

Trouble is, other teams fighting their way into that tournament mastered similar statistical challenges. Once there, almost everyone is above average by either luck or design. Under those new circumstances, it’s unlikely that percentage football alone will produce multiple wins. In simplest terms, the things that get you to the playoffs aren’t the same things that get you through the playoffs.

That’s the critical lesson. 2010 was a wonderful year of progress for the Chiefs. Evaluations have already started and I’m certain that plans are being made for 2011 even as I write this. They know they have work to do and I know they are already on it. They certainly know more about the specific needs and details than I do. My expertise is with statistics and investing.

Index funds make perfect sense as part of a long-term investment strategy. They are low cost, tax efficient, and simple to understand and use. But they rarely make it to a list of top performers. The exact attributes that make them good long-term performers – deliberately-diversified, status quo, boring - also render them impotent against short-run or nimbler opponents. They are wonderful for marathons, but awful in the 40-yard dash.

What I’d recommend for clients is different for the Kansas City Chiefs. I love the marathon approach because long-term is what matters for most family financial goals. I’ve watched people chase top performers, and watched the dismal financial results. For clients, I’ve learned to carefully watch the forest while other people focus on trees. Percentage investing works best.

It’s not good enough for pro football, though. Percentage football is a formula for regular season success —and playoff disappointment. Which takes us right back to Marty Ball and the old Kansas City Chiefs. The timing is perfect for a better approach.
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Dan Danford is founder and CEO of Family Investment Center in St. Joseph, Missouri. The firm is a commission-free investment advisor registered with the SEC. Danford and other advisors at the firm specialize in managing large portfolios of traditional investments. They do, however, advise investors on a broad range of wealth management and other investment services. To learn more about Danford and this unique firm, visit them at 3805 Beck Road, St. Joseph, MO 64506, call (816) 233-4100, or visit http://familyinvestmentcenter.com/.

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