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By Joseph Hogue

The battle to the Super Bowl began at Lambeau Field last night as the gridiron season commences. It also means that fans will be glued to their computer screens for the next four months as they count the points on their fantasy football picks. Fantasy football has grown into an international phenomenon, spawning TV shows, corporations, and tracking software. As a fanthlete myself, though not of the rabid variety, I was wondering if the pseudo-league sensation could tell us anything about investing. It turns out that the best ideas for picking great fantasy teams are also the same ideas that will make you money when constructing a portfolio of investments.

Diversification

Fantasy football players, fanthletes as I call them, plan out a draft strategy before they pick their teams. Players and defensive teams are chosen in a rotating fashion where every participant chooses one of several positions to fill out their roster. Fanthletes choose individual offensive players like quarterback, running back, and receivers then choose a whole defensive line from a team. Drafting can get extremely complicated and dynamic as the rotation continues and some of your preferred players get drafted. The best rosters include a good choice in each of the positions instead of just one star surrounded by a bunch of mediocre players. The best fanthletes plan out a draft strategy to make sure they get a lineup with strengths in more than one area, or a diversified roster. What happens when you put all your faith in a certain Patriots Quarterback and he gets put on the injured list the very first game?

This concept, diversification, is central to investing. Portfolios must have a variety of assets and sectors. Diversification means that when stocks are tanking, investors can sleep well at night because bonds are performing well. Most investors generally choose from a few asset selections such as stocks, bonds, commodities, real estate, and hedge funds. Each asset has different investment characteristics like liquidity, risk, and return. Within the assets, most notably stocks and bonds, are various sectors by which the asset can be separated. Sectors include materials, financials, energy, consumer discretionary, consumer staples, utilities, technology, healthcare, and industrials.

Stock Picking

The guy that just got out of jail might surprise you. Yes, I’m talking to you #7. Though he didn’t play much his first year out of prison, last year Mr. Vick racked up the 2nd most fantasy points of any player. If Michael Vick were a stock, Jim Cramer would be screaming, “Buy, Buy, Buy!”

Right now, housing-related stocks and REITs are only slightly more popular than the plague. Housing construction, as measured by starts, is about a third of its long-term trending average. Additionally, there are millions of foreclosures on the market depressing prices for homeowners that cannot wait to sell their house. But not all is doom and gloom in the housing market. Rental rates are already high enough that ownership is starting to look more attractive. Some areas have such a deficit of rental properties that the government is thinking of ways to convert foreclosures into rentals.

The Vanguard REIT Index (VNQ) is one of the most popular exchange traded funds in the REIT space. Real Estate Investment Trusts (REIT) are funds that invest in a collection of real estate then pay out at least 90% of their income to shareholders to avoid paying federal taxes. The fund pays a dividend of 3.2%, and holds the stocks of 106 other REIT companies including: specialized REITs (26.1%), retail REITs (25.8%), residential REITs (18.1%), office REITs (16.8%), and diversified REITs (7.3%). This aggregation of REITs means that investors won’t lose all their money if a single investment goes south. The fund has performed in-line with the broader market over the last year with a return of 7.1%.

Similarly, the high flyers of one year are not necessarily going to be good picks the next. Randy Moss had a stellar season in 2007, only to bring in marginal points for those that rushed to pick him for the ’08 season. Cisco Systems (CSCO) was the stock to own in the nineties but has done nothing since the tech bubble burst in 2000. Investors are currently discounting the stock because of competition from other technology names like Hewlett-Packard (HPQ) and Juniper Networks (JNPR). I own options on Cisco as I believe the huge cash reserve and strong cash flows are not fully reflected in the stock price.

A caveat here is that there is no way of telling for how long a company’s star will shine. Stock prices can continue to escalate well past any intrinsic value. Additionally, some stocks seem to soar to astronomical heights before going supernova leaving investors with no chance to get out before losses. Other high flyers fizzle out in a more progressive fashion. As a value investor, I tend to sell out of stocks well before the peak in their prices. I miss some gains, but it’s acceptable because I book solid returns and rarely get caught with a precipitously falling stock.

In fantasy football, as in investing, sometimes the neglected and under-appreciated are your best picks. How many people had Peyton Hillis of the Cleveland Browns on their roster last year? How many people knew Peyton Hillis even existed last year? This year he is on the Madden cover and everybody knows his name. The best place to find neglected stocks are those with market capitalizations of less than one billion dollars. Companies of this size are usually classified as small-caps. Fewer analysts work in small cap stocks because there are fewer investors that will pay for their advice. For example, there are 24 brokers listed on Yahoo Finance with price targets for Microsoft (MSFT) but only 7 for Apollo Commercial Real Estate Finance (ARI). Apollo operates as a commercial real estate finance company originating and managing commercial mortgage-backed securities (NYSEARCA:CMBS). As has been the case with most REITs and real estate-related companies, Apollo has underperformed the S&P500 by more than 20% in the last year.

Letting you emotions pick your stocks

Fantasy football fans can get extremely emotional about their players. The love fest for Chad Ochocinco, yes he actually changed his name to 85, is unbearable though the points he puts up are marginal at best. Conversely, everyone loves to hate Ben Roethlisberger but he consistently banks some good numbers.

Letting your emotions control your investments is one of the quickest ways to lose money, yet many investors do it habitually. In fact, emotional investing is so epidemic that a spin-off of traditional finance has been created called behavioral finance. Anchoring is the inability to incorporate new information in the price target for a stock because the analyst already has an opinion. The investor becomes “anchored” in their opinion because of an emotional attachment to the stock or the previous opinion. Even if the investor uses some of the new information, it is usually not weighted as strongly as the earlier opinion. Anchoring most often leads to surprises because the investor has failed to watch market signals and the evolution of the environment. Anchoring is best avoided by establishing at least some quantitative analysis within the investment decision. As economic data is released, such as retail sales, the analyst can objectively reassess the value of the holdings within the portfolio. I wrote an article last month outlining several other pitfalls in letting your emotions manage your stock portfolio.

Monitoring and Rebalancing

In fantasy football, fanthletes can trade players weekly to adjust the strengths and weaknesses in their rosters. People jumping in and out of a pick are usually the ones that end up on the bottom of the points list. They drop a running back because he had one bad week. Someone else picks up the same running back and catches the rebound week for big points. The winners follow the trends and read the scouting reports. Jumping in and out of a stock can have the same cost for an investor. When news breaks of missed earnings or margins slightly under pressure, the stock plummets and investors run for the exits. Savvy investors, informed by their own research of long-term trends and fundamentals, come in to buy the stock. In fantasy football, a single game is not usually cause to drop a player. Similarly, in investing, a solitary event may not mean an asset cannot still be a good investment.

Just as trading stocks carry extra fees and commissions, some leagues in fantasy football charge participants a fee for trading players. Some fanthletes still trade fanatically, just as some investors trade into a stock only to sell it away within a few days. Rebalancing your team is sometimes necessary though. It does no good to irrationally hold a player experiencing an unending slump. The best fanthletes have a formal system for monitoring and rebalancing their teams.

It does no good to irrationally hold a stock if the company has lost its competitive advantage within the industry. The best investors have a formal system for monitoring and rebalancing their assets, sectors, and individual investments. There are two primary ways to monitor and rebalance your positions, calendar and percentage-of-portfolio. Calendar rebalancing dictates the least amount of time monitoring. Positions are changed back to strategic target exposures every quarter or year by selling a portion of the assets that have increased in value and buying more of the assets that have declined. Calendar rebalancing, in addition to less monitoring, usually incurs less trading costs and tax consequences as well. If rebalancing is done on an annual basis, capital gains will be taxed at a lower rate and investors will pay relatively fewer commissions than a more frequent rebalancing.

Percentage-of-portfolio rebalancing is adjusting the amount invested in an asset whenever its dollar size relative to the total portfolio deviates from a target percentage. This target percentage, or more commonly a range, is set to ensure diversification within the portfolio. An investor may start out with 60% in stocks and 40% in bonds with acceptable ranges of plus or minus five percent. Depending on the market, either asset could rise or fall outside of its target range. When this happens the portfolio is exposed to too much risk specific to the over-performing asset and needs to be rebalanced. This could happen in a day, a month, or may take several years.

Many investors use percentage-of-portfolio rebalancing as a method of market timing. Given a large enough target percentage range, deviation by an asset could mean that it has declined or increased in price too much. There are drawbacks to percentage-of-portfolio rebalancing. In volatile markets, narrow target ranges may require an investor to trade frequently incurring trading fees and higher taxes. Additionally, percentage-of-portfolio means constant monitoring. For the neurotic stock watcher like myself, devoting time each day or week may not be a problem. For those with a life outside the capital markets, portfolio monitoring on even a weekly basis may be too tedious. Fortunately, most on-line investment sites have an alert function that will send you an email if an investment moves outside a predetermined range.

Despite what my wife might think, fantasy football is a game of strategy and analysis. While looking for sage stock picking advice from Sunday kickoff might not make you the next Warren Buffett, there are valuable lessons from both worlds. Novice investors, or newbie fanthletes, should look for other resources describing some of the concepts in this article. Go slow at first and make rational decisions. The best of both worlds know that it’s not the winner of one game that comes out ahead, but the one with the most points at the end of the season.

Disclosure: I am long CSCO.

Source: What Fantasy Football Can Teach You About Investing