Investment Lessons From the NBA

6/5/2023

The Miami Heat have reached the NBA finals, which is only the second time in NBA history for a No. 8 seed (the first being the NY Knicks in 1999).  The Heat have shown themselves to be giant killers, dispatching with the No. 1, 2, and 5 seeds on their path to the finals.  The most striking thing about this team is not just their lack of star players but that so many of their top contributors went undrafted. 

In game three of the Heat’s series with the Boston Celtics, which the Heat won 128-102, the three highest scorers in the game (across both teams) were undrafted Heat players.  Four of the Heat’s seven players to log at least 20 minutes in the game had been passed over in the NBA draft.  In that same game, the Boston Celtics starters were all first round drafts.  Three of them were the 3rd pick (different years, of course), one was the 6th pick, and the other the 29th pick.  Of the Celtics’ six players to play more than 20 minutes in the game, all were first-round picks.

The NBA drafts 60 players each year.  Three of the Heat’s undrafted players were passed over in the 2019 draft, which means that NBA teams have had 240 opportunities to find better players through the draft since then.  Yet there they were, a team with four undrafted players dominating a team of high first-round draft picks.

Stock picking has similarities with sports drafts.  In sports drafts, countless hours are put into screening and evaluating players with the hope of building a team that will outperform all others.  Likewise, active managers (aka stock pickers) work to build ‘teams’ of stocks with the hope of outperforming an index. 

Just as in sports drafts, successful stock picking is difficult to do well consistently.  According to the investment firm Vanguard, over the trailing 15 years through March 2020, 63% of active stock managers underperformed their index.  For those managers who perform well, it is difficult to stay at the top.  In its ‘US Persistence Year-End 2022’ report, Standard & Poor’s reveals that of stock managers who outperform over a given 5-year period, only 31% outperform over the next 5 years.

While we see a role for active management, such as with small company stocks or regionally focused strategies where specialized expertise can outperform, the ability to purchase broad indexes of stocks easily and cheaply has proven a meaningful benefit to investors.  Unlike the NBA, investors can opt out of the draft and instead purchase the entire pool of ‘talent’ (equities). 

Such a concept wouldn’t work in the sports world, where the entertainment of competition leading to winners and losers is the point of it all.  But when investing, the point of it all is prudently compounding wealth and/or building income over the long term.  That is often boring, which brings to mind the Warren Buffett quote, “Beware the investment activity that produces applause; the great moves are usually greeted by a yawn.”

Jeff Buck