Blindfolded monkeys throwing darts
Could a blindfolded monkey throwing darts at a newspaper’s financial pages select a portfolio that would do just as well as one carefully selected by experts? This was the amusing premise offered by Princeton professor Burton Malkiel in his bestselling book, A Random Walk Down Wall Street. Turns out he was wrong, according to a study summarized in a 2012 Forbes article.1 In fact, the monkey outperformed both the experts and the stock market.
When you read a little further into the article, you discover that the monkeys did indeed have some help from the risk premiums offered by small cap and value stocks (which we’ve talked about in previous articles). Because 30 large companies accounted for about 40% of the stock market capitalization weight over that time period, any darts thrown at a list of 1,000 companies would have included mostly smaller companies, which outperformed the market during the period covered by the study (1964 – 2010).
The point of this research into randomness is that someone who claims to have an advantage in selecting stocks, or nosing out those that are undervalued by the market, is probably going to have a hard time consistently delivering on that promise. That person would have to have more precise knowledge of particular stocks or market conditions that other very smart, very well-informed investment professionals do not have. In the age of the internet, where anyone with a smart phone has access to an overwhelming amount of information about the markets, that’s a hard position to maintain. Anyone who manages it for a time is probably relying as much on luck as science.
Let’s take the example of an auction. There was a time when someone with some solid knowledge of, say, farm equipment, could go to an auction and be fairly certain of snagging a real deal, particularly if there were few buyers present who were interested in the same equipment. However, in recent times in Saskatchewan, there are a growing number of corporate auctions – particularly for farms or heavy machinery – that are now posted online. The potential buyers are scattered not only all over the province, but throughout the rest of Canada and the United States, and even Russia. This breadth of buyers and bidding protocol virtually guarantees that the prices gained for items on sale will reflect fair market value. There will be enough knowledgeable bidders taking part in the auction that it is very unlikely that something will be significantly undervalued because people do not understand its true worth and therefore sold at a discount. In other words, online auctions are an efficient way to determine the present value of anything that is posted for sale.
In a diversified and transparent market, this same mechanism works to establish the value of the Canadian dollar versus other currencies. There are many buyers constantly pushing the price around based on available information and future expectations. This means that the current price of our dollar against, say, the US dollar is a reasonable value based on available information. The same is true of a piece of real estate. Those who hang on to a piece of property because they cannot get their asking price may blame a sluggish market, whereas in this hyper-connected world, a multitude of potential buyers will have assessed the price to be too high based on the information that is available at the moment.
You will have anticipated that the same reasoning can be applied to the stock market. The concept that the markets are efficient assumes that the price of any given stock at any given time reflects all the information that is currently available about that stock. Furthermore, stock prices immediately react to news about the market. Therefore, knowing what a stock did on one day does not give you any information about what it might do in a week or month or year.
So, as we reflect on the image of monkeys choosing stocks by throwing darts at the financial pages, let’s keep in mind that predictable components of stock pricing are due to changes in the risk premium. There are rational ways of constructing a portfolio, but stock picking is not one of them.
1. Ferri, Rick, Forbes, December 20, 2012. References study by Research Affiliates where 100 portfolios of 30 stocks are randomly selected from a 1,000 stock universe. Every year, from 1964 to 2010, they replicated the process of 100 monkeys throwing darts at the stock pages. They found that on average, 98 of the 100 monkey portfolios beat the 1,000 stock capitalization weighted stock universe each year.
Daryn Form is a Senior Financial Advisor with Assante Capital Management Ltd. providing wealth management services to principals of family-owned and privately held companies. Assante Capital Management Ltd. is a member of the Canadian Investor Protection Fund and is registered with the Investment Industry Regulatory Organization of Canada. The information mentioned in this article is for general information only. Please contact him to discuss your particular circumstances prior to acting on the information above. The opinions expressed are those of the author and not necessarily those of Assante Capital Management Ltd. Rates are not guaranteed and are subject to change at any time without notice.