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 ETFs 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 capitalization 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 universe 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. See my latest book, The Power of Passive Investing, for all the facts and figures on index fund investing.
I wish to thank Rob Arnott and Jason Hsu of Research Affiliates for assisting with this blog. They have yet to announce when or where they’ll publish their article on this monkey business. It will be much more in-depth than this brief overview. In the meantime, you can find related articles on the Research Affiliates website.