What Can NBA Roster Construction Teach Us About Investing?
The NBA playoffs are nearing an end and It’s been clear that two teams have stood above the rest of the competition, The Golden State Warriors and The Cleveland Cavaliers. What do those teams do differently compared to other NBA teams and how can that possibly relate to investing? Let’s look at some common mistakes NBA teams make in terms of roster building and how that mirrors the issues I see with investment portfolios.
Too Much Overlapping Talent
This past year The Orlando Magic had two developing big men, but in the off-season, they decided to trade for and sign another two big men with overlapping skills. How did that work out? They didn’t make the playoffs.
Chris Paul, John Wall, Isaiah Thomas, Kyrie Irving and Russell Westbook are all great point guards. Individually, they are all amazing basketball players. Collectively, they wouldn’t make a great NBA team since they have overlapping skill sets, talents and don’t have size.
Many portfolios I see will have a heavy concentration in one asset class such as Large Cap Stocks (U.S. based companies) or worse yet one individual stock. Other portfolios will have a collection of mutual funds that people think diversifies their portfolio. Many mutual funds will end up holding several of the same stocks which translates into a good amount of overlap in portfolios.
It’s good practice to understand the underlying holdings of a mutual fund to ensure that your portfolio isn’t heavily weighted towards one position. An investment portfolio should also have several different asset classes; Large Caps, Mid-Caps, Small Caps, International Funds, Real Estate, Bonds, etc. Since, like NBA players, asset classes perform differently and the right mix will ultimately provide balance to a portfolio.
Overpaying for Past Performance
Dwayne Wade is a future hall of famer and has already had an amazing career. This past offseason, The Chicago Bulls signed Wade to a large contract based on his past performance. He’s gotten older and his skills have declined. As a result, Wade wasn’t able to produce up to the value of his contract. This happens all the time in sports, but it also happens in investing.
I see many people try to chase the returns of the past year’s winners. Often in investing, the last year’s winners become the next year’s losers and vice versa. For example, in 2015 the Large Cap Value index had a negative return of 3.83%, but in 2016, the Large Cap Value index returned 17.34%. In 2017, Large Cap Value Funds are under performing Large Cap Growth. Investors should not allocate their funds towards investments based solely on their performance in the past year or month.
They Don’t Maintain Flexibility
Basketball players command a very high salary and the bad basketball GMs sign mediocre players to expensive contracts. Eventually, their roster is filled with overpriced players and they can sign or trade for anyone one else because they no longer have cap room.
I see a lot of people invest their money in just one investment vehicle. Often, that investment vehicle is a 401k plan. 401k plans can be a great investment option, but your money can be locked up for several years or even decades. There are other investment options such as a Roth IRA, Investment Accounts, Annuities or Permanent Life Insurance that can provide greater access or flexibility. An investor should diversify their investment vehicles just like an investor would diversify their asset classes.
The best NBA teams have a set of players that are dynamic, provide different talents and will perform differently depending on the situation. Investment portfolios are should be constructed in the same vein.