Can Monkeys Outperform the Financial Market?

By akohad Oct14,2022

[ad_1]

“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 wrote this in his 1973 book “A Random Walk on Wall Street,” which sparked much debate. Without a doubt! The entire foundation of active fund management was under attack, and a statement like this made them appear not only incompetent but also comically absurd.

The fact that someone tested Malkiel and demonstrated that he might be correct took the cake! The Wall Street Journal reported on an experiment in which a monkey chose a small number of stocks that consistently outperformed the market. Famous TV host John Stossel conducted his version of the investigation, substituting a monkey, and reported higher results.

In 2012, a cat named Orlando made headlines after narrowly defeating a team of investors over a year. It made “trading decisions” by sprinkling a toy mouse on a grid of numbers assigned to various companies. The result? The cat made £5,542, while the investment professionals made £5,176!

Another ridiculous case involved Michael Marcovici, an Austrian concept artist who bred and trained “rat traders” with names like Morgan Kleinsworth and Mr. Lehmann, claiming a 57% accuracy rate!

Isn’t that crazy? But there’s an unspoken truth here: most animal prophets who pick stocks fail. Is there more to this than entertaining anecdotes? Even a broken clock is correct twice a day, so is there more to this than amusing anecdotes? Can the “monkey index fund” withstand an experiment?

That’s precisely what Research Affiliates LLC’s Robert Arnott and his team discovered.

Instead of managing a monkey, the team simulated a monkey’s picks by randomly selecting 30 stocks from the top 1000 by market capitalization and creating an equally weighted index. The same procedure was repeated 100 times, and the average returns from 1964 to 2012 were compared.

Burton Malkiel claimed that a monkey could outperform mutual funds. He was mistaken. The monkey outperformed the market 96 times out of 100!

The monkey outperformed the market cap benchmark by more than 1% in 75% of the cases and earned a relative profit of more than 2% in 30% of the cases! The monkey index fund’s returns were higher and better in terms of risk-adjusted return based on the Sharpe ratio. However, the risk was slightly higher in terms of standard deviation.

This was not the only experiment conducted. Cass University researchers adapted Rob Arnott’s experiment to create their own: they selected stocks from a pool of 1000 without regard for equal weighting and compared the returns to the market — they did this for 10 million different portfolios each year between 1968 and 2011. The results were astounding:

  • In 1968, a $100 investment in the US market would have yielded just under $5000 by the end of 2011.
  • More than $8,700 was generated by half of the monkeys.
  • A quarter of the bet returned more than $9,100.
  • 10% earned more than $9,500 — a profit of 940% or more!

However, the research went a step further. From 1972 to 2012, the 3-year rolling average of the monkeys’ performance was taken and compared against the market cap fund year by year to see what proportion of monkeys beat the market yearly. These were the outcomes:

These figures demonstrate how all-or-nothing the entire venture is. The monkeys outperformed the market 57% of the time but underperformed it 31% of the time. The timing is also telling: the monkeys beat during bull markets but underperform for extended periods during bear markets. This is where the psychological aspect enters the picture. It’s all fun and games when things are going well, but would you bet on a monkey’s predictions to perform worse than the market for 5 to 6 years in a row?

It’s no joke that the monkeys outperform the market cap funds roughly 60% of the time. According to previous data, the average performance over the entire period is also better than market cap funds.

So, how did they pull it off? Were the monkeys genius stock pickers?

Before you go out and buy a dart-throwing monkey, let’s try to figure out why this works in the first place. The reason for the monkeys’ success is hidden in their failures. When you look at the data collected by the Rob Arnott team again, you will notice two things:

The monkey index fund has higher volatility (beta).

Market index funds that are equally weighted outperform even monkey index funds.

The process by which market index funds are created may be more important than the individual stocks chosen for the fund. The weightage given to companies in market cap-based index funds, such as the S&P500, is not equal — it is based on their market capitalization. These funds are supposed to provide more stability to the portfolio during times of turmoil because they do not fluctuate as much. However, your expansion opportunities are limited because big companies can only grow so much.

On the other hand, an equally-weighted index fund captures the growth of small and value stocks as well, but at the cost of (allegedly) higher volatility. This happened when the monkeys picked random stocks: equal exposure to a few small stocks that saw massive growth balanced out the losses from other stocks. However, because of the risk involved, it appeared to be a gamble.

Equally weighted index funds have outperformed SPY by more than 100% since 2000. The catch is that while the Sharpe ratio appears to be similar, the volatility was higher in the case of equally-weighted funds, as shown by the standard deviation, with higher drawdowns during crashes. These stocks’ higher returns were a trade-off for their exposure to volatility.

If you put an infinite number of monkeys in front of (strongly built) typewriters and let them clap (without destroying the machinery), one of them will produce an exact version of the ‘Iliad.’ Would any reader bet their life savings on the monkey writing the ‘Odyssey’ next after finding that hero among monkeys?

The exceptional performance of randomly selected stocks does not imply that any pick you make will be successful. It simply means that where there are outsized rewards, there are also excessive risks. Most unknown stocks that make headlines for their exponential growth fall into one of two categories: small stocks or value stocks, and investing in them rewards you for the risk you are taking. Market beta, market value, and market size — The nature of your portfolio is determined by your exposure to these three.

What you should take away from this article is that you do not have to be constantly exposed to these three factors! A market capitalization-based Index fund may not be the only option for safe investing. There are other options with a slightly different risk-reward ratio.

Start trading with Grand Capital and no monkey business:

https://grandcapital.net/

New to trading? Try crypto trading bots or copy trading

[ad_2]

Source link

By akohad

Related Post

Leave a Reply

Your email address will not be published. Required fields are marked *