What Can The NFL Draft Teach You About Stocks?
No. 1 draft pick Myles Garrett was one of five college stars drafted from Texas A&M in last week’s NFL draft. No. 4 pick Leonard Fournett was one of five from LSU. Michigan State was home to a staggering 17 picks by the time the draft was done.
The punchline: a slim 14% of the schools produced more than 40% of the 2017 draft picks.
But because of a 100-year-old mathematical rule called the Pareto Principle, I could have predicted the overwhelming number of NFL draft picks coming from a small number of schools.
Conventional wisdom lends itself to a bell curve
Many people assume the performance data that drives NFL draft picks would lend itself to a bell-shaped curve. This “normal distribution” is where performance among the population tends toward average results with a low chance of extreme outcomes.
Statisticians love a normal distribution because it simplifies the world and makes mathematical computations relatively easy and clean. Humans do too because normal distributions reinforce our bias to underestimate the possibility of extreme outcomes.
But the smart money knows performance comes from fat tails
Looking deeper, however, the bell curve loses its luster. In competitive areas like football, outcomes rarely conform to this normal distribution. (New England Patriots, anyone?)
Instead, we commonly observe a Pareto distribution, also known as the 80/20 rule, where 80% of the results are derived from 20% of the population.
Instead of performance tending toward an average, it leans toward the extremes, with a small minority dramatically outperforming the average. Studies have shown the Pareto distribution existing across a diverse range of human endeavors like professional sports and personal finance, for instance.
Stocks and sports – reflections of the same reality
Similar to stellar draft picks, stock market winners tend to follow a similar model.
We analyzed 14,455 active stocks between 1989 and 2015, identifying the best-performing stocks on both an annualized return and total return basis.
Looking at total returns of individual stocks, 3,683 or 25% underperformed the S&P 500 Index by at least 75% during their lifetimes. Likewise, 2,844 stocks (20%) outperformed the S&P 500 by at least 300%. The remaining stocks performed above, at or below the same level as the S&P 500.
Finance, much like football draft picks, is often characterized by these extreme performances. They also share another feature: discipline.
In order to become the one of 6.5% of athletes that make it into the NCAA, which is then narrowed to just 1.5% to make the leap to the pros, you have to have the discipline to continuously provide performance to your team. The underperformers? They get cut.
It should be the same with your investment team: find and reward your MVPs and continuously prune the underperformers to keep the performance drag from ruining your run to the top.