Should You Let A Monkey Pick Your Stocks
/The Perils of Stock Picking
Can a monkey select a portfolio that outperforms stocks selected by experts? Yes, according to Princeton University economist Burton Malkiel who theorized that “a blindfolded monkey throwing darts at a newspaper stock listing should do as well as any investment professional.”
To test this idea, the Wall Street Journal ran a 14-year contest to find out if stock-picking really was just monkey business.
Beginning the contest in October 1988, the Journal pitted investment professionals against its staffers, who acted as the “monkey”—using a live animal posed a liability risk—and made stock picks by throwing darts at a dartboard of public companies every six months.
So who won the contest and by what margin?
Even though the “monkey” won from time to time as reported in a 2001 Wall Street Journal article titled “Blindfolded Monkey Beats Humans with Stock Picks,” the pros eventually came out ahead, winning 61 out of 100 contests. While these results were 20% better than what you’d find in an efficient market, the pros—all smart and well-educated—still lost 39% of the time to randomly thrown darts. Their performances against the Dow Jones were even less remarkable. And that’s not even taking into account taxes or research and trading costs, which would have lowered their results further.
In the end, the fact that throwing darts at a board came close to the professionals’ carefully selected stock choices shows there’s a great degree of randomness and unpredictability when picking stocks.
Profits and Growth Matter – But Are Nearly Impossible to Predict
So why is predicting individual stock performance so difficult? Isn’t stock performance primarily a result of a company’s profits and profit growth?
Yes, but only sometimes. To be sure, the main driver of stock performance is usually a company’s profits (aka earnings) and profit growth over time. In fact, the S&P 500 index movements trend very closely to earnings and earnings growth over long periods of time.
In addition, the most common metrics used by the professionals for evaluating stock performance are P/E Ratio (Price to Earnings Ratio) and the PEG Ratio (Price to Earnings Ratio divided by projected Earnings growth), which are primarily comprised of earnings and growth. These ratios are readily available public information.
With that said, there are different ways to calculate these numbers and various “earnings” (GAAP or non-GAAP variations) that are used. As one financial analyst once explained in a presentation, “You can make these numbers look like most anything you want them to be, depending on timeframe and underlying company metrics.”
Handling the Unknowns
Another challenge is the unknowns. From regulatory challenges to management dilemmas to breakthrough competitive threats, unpredictable situations can wildly impact a company’s profits. On a daily basis, the media sound nasty alarms like “Jet buyers drop Boeing 737 Max orders.” They also report upbeat rings like “Tesla is profitable again.” With this type of breaking news, stocks respond in seconds.
Inevitably, the difficulty in picking winning stocks boils down to six main points:
1. Profit and earnings growth data can be difficult to predict. Having worked in four very successful public companies over the decades, I was in the sweet position to receive stock options and stock shares. Along my journey, I had fairly close contact to metrics and financial data. Yet it was still nearly impossible to guess which way the stock was going to go. Now I get to manage money for several “insiders,” and I would say that their opinions on stock direction are often no more reliable or certain than an individual off the street. This is the case in part because having true “insider information” is illegal and can send you to jail, just like Martha Stewart in 2004.
2. Humans rely heavily on gut instincts. Many investors prefer to make stock-picking decisions based on hunches rather than actual metrics. We humans are very emotional creatures and, when faced with ambiguity, have a tendency to lean too much on gut instinct and “good feeling.” In some cases, a stock pick is made because an investor believes in the founder or what the company stands for … instead of hard data around earnings.
3. Large cap stocks are often favored. We have a bias toward large cap stocks that are well known, though history tells us that smaller, lesser known stocks are more likely to outperform.
4. Most stocks fail to beat the market. This is true in any given year. And those stocks that outperform the market don’t beat it by much. Consider these useful data points reported by Michael Cembalest in an extensive JP Morgan study of the broad Russell 3000 index, which most widely matches the broad market.
· "The excess return on a median stock since inception compared to the broad Russell 3000 index was negative 54%."
· “Two-thirds of all stocks underperformed versus the Russell 3000 Index from the time they were added to the index. And 40% of all stocks had negative absolute returns, suffering a permanent 70% or more decline from their peak value.”
· “The percentage of extreme winners in the index was in the single digits, meaning a very small percentage of stocks carried most of the weight for the remaining underperforming stocks.”
5. Prices fluctuate. When it comes to stocks, good times won’t last forever and neither will bad times. Having seen investors first-hand ride a stock price up to new heights, I know how hard it is to get out before things turn south. Even with the possibility of investing in a true winner, investors often don’t sell out soon enough and ultimately lose the ground they achieved.
6. Limiting stocks leads to more volatility. In order to beat the S&P 500 Index, you must be willing to concentrate funds in a limited number of stocks, typically fewer than 20. By doing so, you position a portfolio to be more volatile and have a greater likelihood of losing big compared to the broad index.
Tips for Smart Investing
So, ultimately, what is an investor to do?
One option is to avoid individual stock picking with your “serious” money: the funds you’re counting on for retirement, for sending kids to college, or funding your kitchen remodel. Instead, invest in a broad-market, low-cost index fund that not only puts you on the path to stock market returns but also gives you a much greater degree of reliability for achieving your financial goals.
Still feel compelled to dabble in some stock picking? Before you act, take heed of what Benjamin Graham, author of the Intelligent Investor, once said: “The investor’s chief problem—and even his worst enemy—is likely to be himself.”
If you decide to give stocking picking a try, carve out no more than 10% of your investment dollars. Measure your performance versus an index, then assess whether it’s worth the time and effort.
In 2002, the Wall Street Journal finally ended their annual stock picking competition, stating that it had nothing to do with the results of the investment professionals versus the darts. The Journal’s Dartboard Contest was never a perfect representation of the stock-picking expertise of monkeys versus professionals, but it did test the efficient-market hypothesis and gave investors something to think about.
Long story short is that, except in a very rare occasions, no one is knowledgeable enough to beat the market over an extended period of time with individual stock picking. When life goals require certain returns, choosing an inexpensive, well-diversified fund is going to more reliably deliver you into your desired future.
Sources:
Kueppers, Alfred. (June 5, 2001). “Blindfolded Monkey Beats Humans With Stock Prices.” The Wall Street Journal. Retrieved from https://www.wsj.com/articles/SB991681622136214659.
Carlson, Ben. (Mar. 24, 2019). “How Often Is It a Stock-Picker’s Market?” A Wealth of Common Sense website. Retrieved from https://awealthofcommonsense.com/2019/03/how-often-is-it-a-stock-pickers-market/.
Past performance is no guarantee of future results. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Investing involves risks.
Wealthrise Financial Planning is an investment advisor registered with FINRA. This material is provided for informational and educational purposes only. It should not be considered investment advice or an offer to buy or sell securities.
