Monkeys Are Better Stockpickers

Than You'd Think - “Barron’s”

"A blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that
would do just as well as one carefully selected by experts," Burton Malkiel famously argued in his
classic 1973 book, A Random Walk Down Wall Street. Malkiel may have given too little credit to
monkeys.
Start with the record: U.S. large-company mutual funds have routinely failed to beat the Standard &
Poor's 500 index since S&P began keeping score in 2002. Over the past five years, for example, 73%
of active funds have fallen short of that benchmark. Today's fund families may appear well-stocked
with winning funds, but that's in part because 26% of U.S. stock funds were merged or closed during
the past five years.[ SURVIVORSHIP BIAS]

Now consider that the S&P 500 isn't a good proxy for the stock-picking prowess of monkeys. Most
of them, given enough darts, would have clobbered the index in recent years. That's because the S&P
500 weights companies by market capitalization, or the cost to buy all of their shares. Large
companies have the most sway in determining returns. Monkeys don't care for cap-weighting; they
prefer to equal-weight companies as their darts find their mark.

A March study by London's Cass Business School found that among 10 million randomly created
indexes, each with 1,000 U.S. stocks in equal weights (that is, monkey portfolios), nearly all of them
beat a cap-weighted index from 1968 through 2011. In a recent report, Tim Edwards and Craig
Lazzara at S&P Dow Jones Indices point out that the S&P 500 Equal Weight index has returned
9.1% a year over the past 15 years, beating the S&P 500 cap-weighted index by a whopping 4.6
percentage points a year. One reason might be that an equal-weight index avoids plumping up
exposure to market pockets where prices are rising the fastest—like dot-com shares in the late 1990s,
before the 2000 tech crash.

Compare active funds with an equal-weight index, which arguably is more representative of the
choices stockpickers face, and the results go from bad to worse for fund managers. Two reasons:
Fear of underperforming peers keeps most fund managers hugging the cap-weighted S&P 500 with
large portions of their portfolios, erasing the equal-weight advantage that monkeys have long
enjoyed. Edwards and Lazzara find that the relatively small number of fund managers who stray far
from the S&P 500's weightings have posted the best returns—but they caution that these truly active
stockpickers are only as good as their picks. The second reason is fees, which are typically higher for
actively managed funds than for index funds. The paper clears up another mystery. S&P 500 Pure
Growth and S&P 500 Pure Value, indexes that track stocks with opposing sets of attributes, have
both beaten the S&P 500 over the past 15 years. But that's because they don't use cap-weighting.
Comparing them with the 500 Equal Weight index shows that Value did better and Growth did
worse.

Key Takeaways 
More mutual-fund investors should choose cheap index funds over pricey active funds. That's a
familiar refrain to many, but 87% of fund money is still under active management. Among fund
holders who choose active management, benchmark-straying is a necessary (but not sufficient)
condition of success. Alternatives to cap-weighted index funds are worth a look. Equal-weight ones,
like Guggenheim S&P 500 Equal Weight exchange-traded fund (ticker: RSP ), tend to have increased
exposure to value stocks and smaller companies than cap-weighted 500 funds, and different sector
allocations—less in tech and health care at the moment, and more in utilities and industrials. There
are also funds that weight stocks by fundamental factors like cash flow and dividends, including
Schwab Fundamental U.S. Large Company Index Fund (SFLNX ), which achieves the value tilt
without the smaller-company emphasis.
 Any Monkey Can Beat the Market
DEC 20, 2012 @ 09:05 AM PERSONAL FINANCE FORBES RICK FERRI

Give a monkey enough darts and they’ll beat the market. So says a draft article by Research
Affiliates highlighting the simulated results of 100 monkeys throwing darts at the stock pages in
a newspaper. The average monkey outperformed the index by an average of 1.7 percent per year
since 1964. That’s a lot of bananas!

What is all this monkey business? It started in 1973 when Princeton University professor Burton
Malkiel claimed in his bestselling book, A Random Walk Down Wall Street, that “A
blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that
would do just as well as one carefully selected by experts.” “Malkiel was wrong,” stated Rob
Arnott, CEO of Research Affiliates, while speaking at the IMN Global Indexing and ETF
conference earlier this month. “The monkeys have done a much better job than both the experts
and the stock market.”

In their yet-to-be-published article, the company randomly selected 100 portfolios containing 30
stocks from a 1,000 stock universe. They repeated this processes every year, from 1964 to 2010,
and tracked the results. The process replicated 100 monkeys throwing darts at the stock pages
each year. Amazingly, on average, 98 of the 100 monkey portfolios beat the 1,000 stock
capitalizations weighted stock universe each year.

Nice trick! What’s the deal? No trick. Just send me $10,000 and I’ll sell you the best stock-
picking monkey that money can buy! Seriously, the trick behind the outperforming portfolios
had nothing to do with monkeys or darts. It’s all about smaller company stocks and value stocks
outperforming the market over the period.
From 1964 to 2011, the annualized return for the 1,000 stocks used by Research Affiliates was
9.7 percent. The 30 largest companies in the 1000 made up about 40 percent of the capitalization
weight, but their return was only 8.6 percent annually. The other 970 stocks made up 60 percent
by capitalization weight and their return was 10.5 percent annually. That’s a 0.8 percent per year
premium return for smaller stocks over the 1,000 stock universes and a 1.9 percent premium
return over the largest stocks.

Any portfolio of 30 stocks randomly selected from the list of 1,000 stocks is bound to include
mostly smaller companies. Since small companies outperformed big companies, this is how
Malkiel’s monkey portfolio beats the market. It also helped that the 30 stocks in the monkey
portfolio were equally weighted by Research Affiliates. This technique reduced the average
market cap relative to the cap weighted index and helped boost the return. In addition, equal
weighting “tilted” the portfolio toward value stocks, which earned a higher return than growth
stocks over the 1964 to 2011 period.

Before running down to the local pet store and ordering your dart-throwing monkey, consider the
other side of the story. Where there is extra return, there’s usually extra risk. You can bet there’s
more risk if beating the market was as simple as buying a monkey to throw darts. Portfolios that
hold a higher concentration in small-cap stocks and value stocks have more risk than the market
as a whole. The small-cap premium is widely recognized in academia. It’s the extra return
expected for taking risk by investing in smaller companies. These companies may not be well
known, may not be global, may not be well capitalized, may only have a few products, and may
not have large distribution networks for their products. That makes them riskier than larger
companies.

In addition, smaller companies also have to pay more than large companies when borrowing
money. So, it’s logical that equity investors would expect to earn more relative to larger
companies. The small-cap premium is eloquently deconstructed by the Fama-French Three
Factor Model. This model compares a portfolio return to three distinct risks found in the equity
market: beta – which is co-movement of all stocks in general; size – which relates to the size of
companies in a portfolio relative to the market; and value – which compares the amount of value
stocks to growth stocks.

There’s no such thing as a free lunch on Wall Street. Portfolio return is a combination of beta,
size and value. The level of these three risks in a portfolio gives it a unique risk and return
fingerprint. You really don’t need an animal to pick stocks for you, or a human for that matter.
An all index fund portfolio in all asset classes all the time has a much higher probability of
outperforming most portfolios that are trying to beat the market.
 Instructions
1. Read the two Articles, " Monkeys Are Better Stock-pickers Than You'd Think"
and "Any Monkey Can Beat the Market.
.

      A. Critical Thinking: Why are monkeys so successful at investing,  and often able
to beat Professional Managers?

      B.  Theoretical: What are the implications of this for financial "Market Efficiency"?

       C.  Practical: You have inherited $100,000 from your family. Given the choices
below, what would you do, and why?
                  - Passive Strategy:  Invest in an Index fund like S&P 500
                  - Active Strategy: Invest in Individual Stocks and actively manage the money
                  - Outsource Strategy: Employ a Professional financial advisor and pay the
fees to manage the money

       D. Implications: What are the 'Positives' and 'Negatives' of your investment