What We Can Learn from the Football Draft

Portfolio Diversification

What We Can Learn from the Football Draft

Uncertainty is a fierce opponent, whether you're picking players or securities. Investors, however, can learn valuable lessons from how football teams approach their annual drafts to help build stronger, more durable portfolios.

 

Every year, professional football teams enter the draft seeking to strengthen their rosters with new players and skill sets. There are some notable parallels between that process and investing, with the draft providing valuable lessons on portfolio diversification.

Both players and investors face fierce opponents, but for investors, the opponent can be even harder to tackle. It's uncertainty, and it is becoming increasingly powerful, thanks to the unpredictable geopolitical environment and the return of whipsaw volatility to the equity markets.

Uncertainty wins when investors make poor, emotionally-driven investment decisions, like selling at the wrong time and missing out on potential long-term contributions of the market toward their objectives.

To elevate the chances of overcoming uncertainty and achieving their goals, investors might take a page from football’s playbook: once a year, look to improve your team with your own portfolio assessment. In the meantime, consider these important lessons:

 

Lesson #1: Have a Game Plan

To assemble a team capable of overcoming uncertainty, start with your game plan. Is it built around an aggressive offense, a strong defense, or a balance of both?

An aggressive offense utilizes a high volume of downfield passes and deep routes, seeking big gains. Similarly, investors with an aggressive game plan are seeking growth and their portfolios include higher risk assets, which can include growth stocks, small cap stocks, emerging market stocks, and high yield bonds.

Aggressive game plans can help investors take an early lead, but it’s important to remember the words of Texas Coach Darrell Royal: “There are three things that can happen when you pass, and two of them are bad.”  Alternatively, a more conservative game plan might feature a high number of running plays out of tight formations, moving the ball first down by first down, with the occasional pass. Investors following this game plan have objectives that can include income or capital preservation, possibly with a modest amount of growth -- and place far more emphasis on defense to protect their lead, with assets that can include investment grade and municipal bonds, defensive equities with high dividends and low volatility, and depending on how conservative, higher cash positions. 

Of course, conservative game plans that take fewer chances also run the risk of coming up short on the scoreboard.  Similarly, a defensive-minded team might also lead an investor to miss out on the potential for future market performance.

Every game plan has risks, but clear goals and an actionable plan can help conquer uncertainty.

Lesson #2: Know Your Strengths

Knowing your team’s strengths and weaknesses in executing your game plan is the key when making draft picks. The same holds true for investing.

Investors need to understand if they have the right assets in their portfolio, on both sides of the ball, to maximize their chances  of overcoming uncertainty and achieving the outcome they seek – whether it’s growth, income, capital preservation, or a combination.

On offense, is your portfolio’s equity allocation concentrated in just U.S. large cap stocks? Would a more diversified allocation that includes small cap and emerging market equities improve your chances of overcoming uncertainty? On defense, is your portfolio too conservative? Have you considered defensive equities such as low volatility, high dividend stocks that may reduce volatility while participating in gains? Is your fixed income allocation considering global opportunities; or, is it taking too much risk to reach for income? Do you have too much cash on the sidelines? Are you not taking enough risk – are your assets too conservative and are you running the risk that you come  up short on the scoreboard?

Know the strengths and weaknesses of every player in your portfolio, while also considering what it might be missing.

Lesson #3: Fortify Your Defense

It’s been said that offense wins games (and sells tickets), but defense wins championships. It’s true, there’s nothing as exciting as watching your team light up a scoreboard. Similarly for investors, little matches the excitement of an equity bull market.

But what good is a lead if you can’t protect it? Defeating uncertainty means not only defending the lead when you have it, but also avoiding a devastating loss in the form of a deep and damaging drawdown. Game plans that over-emphasize offense run the risk of a devastating loss.

Winning teams are strong on both sides of the ball. Investors all too often focus only on offense and do not have well-diversified portfolios that include a strong defense. Consider investors who have enjoyed the prolonged bull market in stocks. They may find themselves significantly overweight in stocks thanks to capital appreciation. They're running a very aggressive offense: however, some may be weak on defense  -- with little to protect their lead at a time when they have a lot to protect, and a lot to lose. This creates a significant weakness in their game plan that uncertainty can exploit.

Balance offense and defense in your choices, recognizing that investing is a game of give-and-take.

Lesson #4: Don't Overlook Special Teams

Special teams are situation players who can be key drivers of performance, and often are the difference between winning and losing. 

Field goal and extra point kickers are the highest scoring players in professional football history. These specialists are capable of adding significant alpha. Punters with great precision can be effective defensive assets, while kick coverage units are critical to preventing a sudden, disastrous turn of fate. 

To investors, special team players are tactical assets used to take advantage of alpha generating opportunities, or to add a level of potential lead protection to a portfolio in times of increasing volatility. These assets can include market neutral strategies, commodities, liquid real assets and infrastructure.

Special teams represent opportunities for short-term tactical decisions intended to add to or protect gains.

Lesson #5: Teamwork and Chemistry Are Critical

Players are drafted based on numerous factors, including how well they work with other players as teammates. 

When it comes to investing, the same holds true: well-constructed portfolios are diversified across assets that work together to elevate the certainty of success. 

Consider how this might work on the defense. A defensive lineman has different skills and responsibilities than the safety. If the lineman doesn’t put pressure on the opposing quarterback, that QB has time to throw – which means the safety needs to step up and knock down or intercept the pass. In investment terms, the players are uncorrelated. They need to do their own job but also work together, as teammates with great chemistry, to back up each other -- or they can throw off the entire team.

Selecting uncorrelated assets with complementary attributes is at the heart of portfolio construction.
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