How picking stocks at random can be a surprisingly effective strategy.
There is an old adage that a monkey throwing darts at a table of stocks could pick them better than most Wall Street professionals. Surprisingly, this is true. An article by Research Affiliates, simulating a set of dart throwing monkeys found that the average monkey outperformed the market by 1.7% per year. The majority of mutual fund managers underperform the market. So too, often by an even wider margin, do individual investors. What do the monkeys know that these people don’t?
The monkey has two big things going for it. One, it doesn’t charge any fees to throw its darts. Over time, most of the underperformance of the mutual fund sector can be linked to the fees they have to charge to cover their expenses. This is one of the main reasons why low-cost exchange traded funds (ETFs) have seen such a surge in popularity in recent years.
The other huge advantage the monkey has is that he’s not looking at what stocks the other monkeys are buying. He’s just throwing his darts and letting them land where they may.
Peter Lynch had an amazing run as mutual fund manager of the Fidelity Magellan mutual fund from 1977 to 1990, racking up average returns of 29% per year. And yet, over this same time-period, the average individual investor in Peter Lynch’s fund lost money. The same phenomenon has been observed with other successful funds. The problem is that investors are continually buying high and selling low; buying into a stock or fund after a strong period of outperformance and then selling it when it starts to lag.
The monkey and his darts don’t fall prey to this natural herding tendency. Those darts are unaffected by the nasty behavioural biases that plague us mere humans. Another manifestation of this phenomenon in action is the long-term outperformance of equal weighted indexes. Most of the big indexes that investors follow and invest in through ETFs and index funds are market weighted, meaning they buy more of the big, well known stocks and less of the more obscure names. If instead, you put together an index by buying the same amount of each stock, you’d have what they call an equal weighted index. Over the long haul, these versions of the popular indexes have outperformed their market weighted counterparts by one or two percent a year.
When I first started investing, I took great comfort in the example of the dart throwing monkey. If all I did was pick stocks at random, I told myself, I could probably outperform 90% of Wall Street veterans. I just had to make sure I wasn’t consciously or sub-consciously buying whatever the herd was into at any particular point in time. Also, that I wasn’t buying stocks simply because they had gone up in price or selling them because they had gone down.
For a first-time investor, the stock market can be a very intimidating place. There are a constant parade of experts on TV and in the financial media with PhDs and other, equally impressive sounding credentials who speak very authoritatively on the markets and the stocks they cover. How could you, as a small-time investor have any hope of competing against these Wall Street professionals? The marketing put forth by the mutual fund and wealth management companies all reinforce this impression.
But the impression is wrong. You are certainly capable of matching or even outperforming the vast majority of those experts. In fact, all you’d need to do is pick stocks blindly out of a hat. Initially, you may be unsure of your analysis or worried that other investors know something you don’t, but keep in mind that even picking stocks at random will give you perfectly acceptable, even market beating, results.
If a monkey can do it, so can you!