What The NBA '3-Pointer' Can Teach You About Investing

A fun lens to examine "prospect theory"

Photo by Markus Spiske on Unsplash

Two things I love thinking about (a lot) are investing and basketball.

So, as soon as I saw a paper in the Journal of Behavioral Decision-Making titled “Reference-Dependent Risk-Taking in the NBA,” I knew I would be writing about it.

It happens to be a very interesting paper with useful parallels to investing.

So, if you like basketball, investing or are just curious about how these two things can possibly be related, keep reading.

The strategy of ‘when to shoot a three-pointer’

The 3-pointer in the NBA is a powerful—but risky tool.

Being worth 50% more points than a regular basket but being a lower-percentage shot than a shot near the basket—makes it the perfect way to analyze risk vs. reward trade-offs in a basketball game.

The research paper by Daniel Mochon explores how NBA players make decisions about when to take the risk of a 3-pointer.

The paper's objective is to determine whether these decisions are influenced by what is called "reference points," which are psychological benchmarks that help people decide whether they are in a situation of gain or loss.

The study is based on prospect theory, which suggests that people make decisions not just based on potential outcomes but also on how these outcomes compare to certain reference points, like a perceived "neutral" position.

The study analyzed data from 10 NBA seasons, including over 12,890 games and millions of individual plays. The author looked at various factors influencing shot selection, such as:

• The score difference between teams when a possession starts

• Changes in score from the previous play

• A teams expectations about winning or losing before a game begins.

The analysis aimed to reveal whether teams behaved more riskily when they felt they were "behind" and more conservatively when "ahead," showing a clear example of how psychological factors can drive decision-making in high-stakes situations.

(Bonus points if you are already connecting the dots on how this relates to investing.)

Let's break down each key finding from the study and talk about how it relates to making rational investing choices.

NBA players (like investors) have reference-dependent risk preferences

NBA teams are more likely to take riskier 3-point shots when they are behind in the score compared to when they are ahead.

In other words, they are willing to take additional risks to recover a recent deficit.

This behavior mirrors how investors might react when their portfolios are performing poorly.

When investments are down, there’s often a temptation to take on riskier bets to try to “make up” for losses.

However, this can lead to even greater losses if the risks don’t pay off.

But there is a MASSIVE difference here.

NBA players have much greater control of their ability to make a 3-pointer than investors do in taking big risks in the market. Steph curry’s talent can influence the odds of him hitting a tough 3-pointer, but financial markets are largely unpredictable meaning you have little (or no) ability to influence the outcome of a risky investment.

What happened on the last play impacts the decision to shoot a 3-pointer

The research also showed that teams’ decisions were influenced by the most recent score change — for example, teams were more likely to attempt a three-point shot if the opposing team had just scored.

Similarly, investors can be heavily influenced by recent market events, such as a sudden drop in stock prices or a surge in another sector. This can lead to short-term, emotionally-driven decisions, like panic selling or jumping on a hot stock or trendy investment.

Expectations and Risk-Taking

The study found some evidence that teams that expected to win were less likely to change their strategies when they were ahead but more likely to take risks when they were behind.

This finding is relevant to investing in that expectations about future market conditions can influence decision-making. Investors often make decisions based on their predictions about what will happen next, such as expecting a bull market and, therefore, taking on more risk.

Then the opposite happens—the market tanks, and investors find out—the hard way—what their true risk tolerance is.

How much time is left on the clock?

The paper found that the weight given to reference points changes over the course of the game, with teams being more sensitive to score differences towards the end of a quarter or game.

So, a team trailing with 30 seconds left in the 2nd quarter would be more likely to take a 3-pointer than if the game was tied.

This suggests that decisions are often influenced by arbitrary time markers.

In investing, a similar bias might lead individuals to make rushed decisions as they approach certain financial milestones.

For example, nearing retirement might tempt someone to shift their investments dramatically without considering if it aligns with their overall strategy. It’s not uncommon for someone to hit retirement and get completely out of the stock market, not thinking about the fact that they still might have several decades to live off of the income their portfolio can generate.

The takeaway is to avoid arbitrary deadlines dictating your investment choices. Instead, regularly review and adjust your portfolio based on changing circumstances and goals, not just because a certain date is approaching.

Investing, like basketball, can feel like a high-stakes game.

But the two key differences are

1. While basketball is a game, investing is serious business with real implications for your life.

2. Skill determines who wins most basketball games while winning in investing is largely a matter of patience and discipline.

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