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Don’t Overreact to Cycles

The run-up to game seven of the NBA Finals teaches some important lessons for corporate executives managing their cash-- as well as a few basketball tips.

As we await game seven of the NBA Finals tonight between the San Antonio Spurs and the Miami Heat it is interesting to reflect on the first six games and in particular the media reaction. 

Each team has won three games of this best of seven series and they have alternated wins back and forth which makes it seem very close but in reality most of the games have been very unbalanced one way or the other.  Games two through five were decided by an average of over 20 points per game.   

The media reacted to each of these lopsided victories as if the result of each single game set a tone that would now dominate the series.  When the Heat won game two by 19, many thought they appeared so dominant they would sweep the next three games to win the series in five.

The Spurs had other ideas when they shocked the basketball world with a win for the ages in game three. They dominated the game to win by an astronomical 36 points, which is the third highest margin of victory in NBA Finals history.  This lopsided win inspired a media buzz suggesting the Spurs would surely win the series.  Sports talking heads mocked Lebron James and his Miami comrades for saying they would win “not one, not two, not three…”

The series has continued to flip back and forth and each step of the way the experts overreacted to the outcome of a single game and extrapolated it forward. 

For those who evaluate company performance and capital market valuation, this sports story sounds all too familiar. Across economies, within industries and even at the level of specific companies we constantly witness overreactions to short term developments that seem completely unfounded when examined in the light of historical cyclical trends. 

There are some very big examples of this that are hard to fully understand when we look back.  Didn’t we all “know” we were in a real estate bubble?  Didn’t we all “know” the meteoric stock market advances of the late 1990s were fueled by an unsustainable internet bubble? 

And didn’t we all “know” that when the stock market dropped over 50% through March 2009 that it had gone too far into a temporary trough and the market would generate very high returns over the next few years while it bounced back?

The reality is most of us didn’t see these bubbles and troughs until after they were over or at least until they were past the peak.  Just like the media covering the NBA, we all have a tendency to observe short term trends and extrapolate them forward.  When business activity and employment are strong we tend to think and act as if it will last longer than it typically does.  And when times are less favorable we also act like it will stay that way for an extended period.


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