Have you heard of the Madden curse? And if you have, do you think it has anything to do with personal finance?
I am here to say, yes! It does have something to do with finance. And I got thinking about this the other day when I overheard some people talking about the dreaded Madden curse.
What is the Madden curse?
John Madden was a legendary football coach, broadcaster, and face of the (still) most popular football video game, appropriately called “Madden NFL.” And I have to admit here that I don’t play this game (or really any video games).
Anyway…every year, one NFL player is selected to be on the cover of the coming year’s version of Madden NFL. Generally, the best or most exciting player from the previous season gets chosen. For example, in 2020, Baltimore Ravens quarterback Lamar Jackson exploded on the scene. So he was chosen for the cover of Madden NFL ’21.
The Madden curse in turn is the trend that the large majority of players that end up on the cover of Madden end up having a much worse season than they did the prior year.
And while this curse has been associated with Madden, the same phenomenon goes for video game covers for any other sport.
How can we explain the Madden curse?
In my mind, it’s actually pretty easy.
It’s a phenomenon called “regression to the mean.” And what this means (pun intended) is that everything has a mean or an average, including a football player’s skill and success.
If one year, the thing being measured, like a football player, does way better than their mean value, what is most likely the next year?
Unfortunately, the most likely scenario statistically is that they regress back to their mean value. To us it seems like they are underperforming. In reality, they are just not over-performing.
Lamar Jackson is still a dang good quarterback. He just regressed slightly back to his mean in 2021 compared to 2020.
It’s important to note that your average mean cash improve or get worse over time. That’s why practice is important. But there is always a mean…
Examples of regression to the mean abound in life
Just think of your own life. How many times do you encounter regressions to the mean?
Whether it is the quality of your cooking, your exercise routine, or even your clinical prowess. Or…it could even be the performance of your investments…
Yes! Regression to the mean is the rule in finance, just like in life. Each investment has a mean. And one that outperforms its mean is more likely to fall back in the future than to keep skyrocketing up.
And this is the downfall of many investors. We see some hot investment, whether it be cryptocurrency or the ARK mutual funds, and we think we need to get in on it. We think it’s just going to keep going up. And then instead it eventually regresses to the mean. And we say, “How come I can never get lucky?” In reality, we just bought the investment “high.”
How can we combat regression to the mean in our investments?
Stop trying to pick individual investments or time the market. We are bad at it. Data shows this. 80% of the time we try to actively predict the path of stocks, we lose.
So, the lesson is that we should invest in the overall market via low cost, broadly diversified index funds!
But how does anyone “win” then?
Like I said, everything, including every investment, has a mean or an average value around which its value at any given time will orbit. This orbit is determined by arbitrary things and things that, frankly, no one can pretend to fully understand.
But, I also said that every mean or average can change over time. Like a football player practicing their skills and raising their average ability. Or getting worse by neglecting practice.
So, in theory, if you can identify an investment with an average value that is due to rise over the long term, that would be a big “win.”
So, as I see it, there are 2 ways to “win” like this:
- Dumb, blind luck and
- Some innate ability or invention that can successfully predict these types of investments ahead of time
In my opinion, only one of these ways is actually possible. And that is luck…
And luck is real in life. For all of us.
The same way, in the example above, an investor bought an investment high, someone can get lucky and buy an investment low. Just by luck.
It’s difficult to surmise that skill is the answer when, again, 80% of active investors do worse than the market average. Heck, that’s even worse than the flip of a coin!
But even passive investors will come face to face with the Madden curse
Because even the overall stock market has a mean. Time and observation gives us a good guess that that mean is consistently going up over the long term. As the economy and humankind “practice” and get better.
But in the short term, we all see the constant rise above and dip below the mean. We get excited and scared by these changes, respectively.
But ultimately, what happens?
Regression to the mean…That’s why I’ve come to love how boring the stock market is…
The bottom line
To build wealth, especially as a high income earner, the name of the game is:
- Create a margin between what you earn and what you spend
- Invest that margin
- Consistently win with your investments
- Avoid big losses
You can even use this simple 7 step formula for yourself here.
But, to consistently win in investing and avoid devastating losses, you need a strategy that uses regression to the mean to your advantage. This means that your strategy can’t require you to successfully predict the direction and frequency of deviations from the mean. Because that just doesn’t work.
So, use a strategy that calls for:
- Investing in low cost broadly diversified index funds,
- Rebalancing back to your set asset allocation once a year so you always buy low and sell high, and
- Combine all of this into a written personal financial plan to guide you to financial freedom
A side note on regression to the mean in real estate
Most of this discussion has centered on stock investing. But what about regression to the mean in real estate investing?
Well, just like everything, the real estate market has a mean. So, similar to the stock market, the goal is to invest in real estate in a way that doesn’t require predicting deviations from the mean.
This is accomplished via cash flow.
As I explain here, cash flow ensures that I don’t care what the actual real estate market is doing. The actual value of my investment property could be $0. But as long as it is cash flowing money each month, I really don’t care.
Now, even market rents have a mean and will fluctuate. So that is why in running your numbers and predicting cash on cash return prior to buying a property, it is so important to be conservative with your rent estimates (and all estimated numbers in general). This gives you a cushion.
What do you think? Have you observed the Madden curse in your investments? How do you react to it? Let me know in the comments below!