5 Investing Lessons From the Warren Buffett Basketball Bracket Challenge

The Men’s Division I Basketball Tournament is often regarded as one of the best sports tournaments in the U.S. After a preliminary four games are played, 64 teams clash in a riveting single-elimination tournament that pulls in fan bases from around the country.

It’s got size, upsets, drama, Cinderella stories, heartbreak, heroes, and villains. And the whole thing is over in less than three weeks.

In 2014, legendary investor and the CEO of Berkshire Hathaway, Warren Buffett, announced he would pay $1 billion to anyone that made the perfect tournament bracket — which involves correctly predicting the outcome of every game. It’s a simple but nearly impossible challenge.

Since then, Buffett has carried forth the tradition and added smaller prizes for selecting the correct winners from the first or second rounds of the tournament. Here’s what makes the bracket challenge so hard, and more importantly, what it can teach us about long-term investing.

Image source: Getty Images.

Nearly impossible odds

The first round of the tournament consists of the top 64 teams in the country split among four different geographic regions — the West, the East, the South, and the Midwest. The teams in each regional group are ranked, or “seeded,” from 1 to 16.

By the second round, there are only 32 teams left, followed by the regional semifinal, the regional finals, the national semifinals, and then the championship game. In total, there are 63 games.

Flipping a coin to predict the winner of each game is a way to fill a bracket. The odds of getting that right would be two to the 63rd power — or 1 in 9.22 quintillion. If you picked the best seed to win each matchup, as in the No. 1 seed beats the No. 16 seed, the No. 2 seed beats the No. 15 seed, and so on, then your odds would improve. But historical data suggests you would still have just a 1 in 46.58 billion chance of a perfect bracket. These near-impossible odds illustrate why Buffett is so confident that no one will pick a perfect bracket.

Lesson No. 1: The market is wrong all the time

The experts who seed each team before the tournament begins are like Wall Street analysts who know the ins and outs of a company. Yet even the experts get it wrong.

According to tournament data, the No. 10 seed beats the No. 7 seed in the first round nearly 40% of the time. Even the No. 14 seed upsets the No. 3 seed 15% of the time in the first round.

First Round Upset

Likelihood

No. 10 seed beats No. 7 seed

39.5%

No. 11 seed beats No. 6 seed

37.5%

No. 12 seed beats No. 5 seed

35.4%

No. 13 seed beats No. 4 seed

21.5%

No. 14 seed beats No. 3 seed

15.3%

No. 15 seed beats No. 2 seed

6.3%

No. 16 seed beats No. 1 seed

0.7%

Data source: NCAA, as of 2018.

The lesson here is that surprises happen all the time. In the case of the S&P 500, there are 2,000 quarterly earnings calls in a year — a lot more iterations than the 63 Men’s Division I Basketball Tournament games. The chances of a single shocking surprise may be small. But when the sample size is that large, there’s a high chance that multiple top companies will report news that no one saw coming.

A stock’s price is essentially the market’s consensus estimate of what the company is worth at a given time on a given day. And just like the tournament seeds, that estimate is often overly optimistic or grossly undervalues what a team or company could be worth over time.

Lesson No. 2: Black swans are always unexpected and never alike

In 2018, the No. 16 seed University of Maryland, Baltimore County Retrievers beat the No. 1 seed Virginia Cavaliers in the first round. And they didn’t just squeak out a win. They won by a decisive 20-point margin. It was the first and only time a No. 16 seed has beat a No. 1 seed in the history of the tournament.

Statistically speaking, the upset was a black swan event for the Cavaliers, and nothing short of a miracle for the Retrievers. Don’t feel too bad for the Cavaliers, though. They would go on to win the entire tournament the very next year in 2019.

Each upset is different, just as no recession is the same. The broader economy was blindsided by the COVID-19 pandemic, just as it was surprised by the financial crisis, the dot-com bubble burst, the oil crash of the early 1980s, and so on. The lesson here is to not react strongly to surprises or blame bad luck when they occur. Rather, surprises are merely par for the course when it comes to investing. Penciling in a degree of randomness will help keep your emotions in check during a sizable stock market sell-off and set realistic expectations so that you can tell when a company becomes overvalued.

Lesson No. 3: Titans fall

Just as unlikely underdogs can dethrone heavily favored winners, so, too, can smaller companies emerge and become more valuable than yesterday’s industry leaders. In 2012, International Business Machines was the fourth-most valuable U.S. corporation by market cap. Today, just 10 years later, it is the 71st largest U.S. company by market cap. Times change, new companies rise, and old ones fall. The best we can do as investors is be roughly right and adapt to the changing economy.

Lesson No. 4: Failure is inevitable

The Men’s Division I Basketball Tournament teaches us that even the favorites don’t get the results they hope for each year. Investing has good and bad seasons, too — also known as market volatility. It’s just about impossible to beat the market every single year, let alone have every company in your portfolio report a good quarterly earnings report. Investing, at its core, is about finding companies that you believe will grow over time — not expecting every trade to go right.

Lesson No. 5: Focus on long-term success

Sports teams try to build a good program by recruiting talented players, practicing disciplined training, and executing good coaching. Similarly, an investor should try to pick good companies, while also keeping their composure when the stakes are high.

When the lights shine the brightest, it’s not the investor who picks the greatest stocks that does the best, but rather, the investor who picks good or even just OK stocks, but has the temperament to stay disciplined and keep their cool. Having the conviction to outlast market volatility and the patience to let your investments compound over time are keys to successful investing.

After all, what good is having the most talented basketball team if panic ensues during crunch time? Or in the case of investing, what good is picking great stocks if you sell them too early before giving the investment thesis a chance to play out?

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Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool owns and recommends Berkshire Hathaway (B shares). The Motley Fool recommends the following options: long January 2023 $200 calls on Berkshire Hathaway (B shares), short January 2023 $200 puts on Berkshire Hathaway (B shares), and short January 2023 $265 calls on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.

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