Abacus: Why a Dart Throwing Monkey is an Investor’s Best Friend

I’ve been casually reading a book called Naked Economics, which is, more or less, a breakdown of basic micro and macroeconomic analysis and applications. Charles Wheelan, the author, is an incredibly entertaining writer and easily turns mundane economic topics and theory into very accessible talking points, sometimes even really entertaining talking points (i.e., I recommend the book if you’re into that kind of stuff.)

I only recently started investing in the stocks and equity markets. Not even playing with big money - more just testing the market and trying to navigate the distinctive differences from the long-term bond market. Wheelan’s chapter on “Financial Markets” appealed to this new “hobby” of mine, especially his four-page explanation and application of the Efficient Markets Hypothesis. 

The EMH is an investment theory that states it’s “impossible to ‘beat the market’ because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information.” This is based on a few observations: A) Everyone investing has access to the same information. Combine ‘A)’ with Supply and Demand theory, and you can understand that if everyone is working with this same information, the price of any one asset will be bid up to the point that the market clears, and these prices obviously will reflect the information that everyone has. In this perfect-game environment, “it is difficult, if not impossible, to choose stocks that will outperform the market with any degree of consistency”, as Wheelan puts it.

This leads us into observation B), the Random Walk Hypothesis. Popularized by economist Burton Malkiel in his investment strategy book A Random Walk Down Wall Street, the hypothesis states that you usually can’t beat the market average because stock price changes and distribution are independent of each other. Hence, there is no consistency in price changes, especially when all available information is outlined. What does matter, as Wheelan outlines in his book, are the things you can’t predict. He recounts this anecdote to drive that point home:

“[N]o one would have predicted that MicroStrategy, a high-flying software company, would restate its income on March 19, 2000, essentially wiping millions of dollars of earnings off its books. The stock fell $140 in one day, a 62 percent plunge.”

Therefore, prices rise and drop without warning and with no way to predict, according to EMH and Random Walk. Past performance won’t determine the future, there’s no get-rich-quick scheme in the equity markets, and your best bet is just to pick a well-known grouping of diverse stocks and stick with it, because they usually give you solid, above-inflation-rate returns in the long run.

Enter: Index Funds. Proponents of the Efficient Markets and Random Walk theories advocate these are literally your best bet for entering the stock markets. What they are: Index Funds are “mutual funds that do not purport to pick winners”, instead, they just pick a grouping of stocks, like all the companies in the Dow Jones, and buy and hold those as the strategy. Firstly, they’re obviously easier to manage, and you incur less costs for management fees, et cetera. Secondly, because they intend to be a market average, one would expect that about half of actively managed mutual funds would outperform the Index, and the other half would underperform. Therefore, if the market is doing well, you will do well (this is even more true in the long-run, where market averages always tend to go up.)

Wheelan goes on to effectively say: Active investing doesn’t outperform passive for long. He states in his book that, according to Morningstar, just less than half of actively managed mutual funds outperformed the S&P 500 over the past year. That number goes up if you look at a 5-year timeframe, where 66% of these funds beat the Index. However, on a 20-year stretch, only 45% of actively managed funds beat the S&P 500. As Wheelan puts it (I’m paraphrasing here), you would actually do better in the stock market, on average, by buying and holding whatever stocks your pet monkey hit by throwing darts at the New York Times stock page.

The book was published in 2010, which implies the above numbers are slightly outdated. However, the reason I wrote about this is that I came upon an article posted in The Economist: “Fund Managers Rarely Outperform the Market for Long.” Which backed up the attractiveness of passive investing by initially positing that “clients have been buying index funds, which passively track a benchmark like the S&P 500 index, and shunning fund managers who actively try to pick the best shares.”

Not only that, but the article presents evidence that, among active mutual funds, performance does not persist. In fact, lets’ say you had picked one of the “best-performing 25% of American equity mutual funds in the 12 months to March 2013. In the subsequent 12 months, to March 2014, only 25.6% of those funds stayed in the top quartile.” That’s a lot less than “chance would suggest.” This leads us to believe that just putting your money into the S&P index will yield larger, more stable long term returns (on average, of course). Not only that, but it requires less management, less costs, and overall involves less risk. The last point is especially relevant when you consider that almost “30% of the worst-performing (bottom quartile) equity funds over the five years to March 2012 had been merged or liquidated by March 2017.”

This article goes on to explain that the average mutual fund is expected to fall short of the market, due to what is known as the “iron law of costs.” Since professional fund managers own most of the market, the performance of the funds are therefore highly likely to resemble the market itself. Funds, one way or another, tend to work their way back to this law, for example:

“Successful managers attract more clients, and the size of their fund grows. So they have to expand the number of stocks they buy, diluting their best ideas. As the fund grows larger, it looks more like the overall market, and runs into the iron law of costs.”

The idea that a stock investor’s best friend has become a random dart throwing monkey, as opposed to a highly qualified fund manager, is not a certain fact. Even Charles Wheelan mentioned a mutual fund that he invested in that significantly outperformed the S&P every year since its inception (called “The Behavioral Growth Fund”). And, there are significant differences across different markets; active management will play a much bigger role in smaller or emerging markets, where information and prospects of certain companies aren’t “so widely available.”

However, American equities are so liquid, and information is so widely spread, that there is simply no specialist knowledge (outside of breaking the law) that can give any active manager a significant edge over the market as a whole. Next time you look at an interesting and successful mutual fund, remember that the fund’s active manager often underperforms our pet monkey throwing darts at the stock page.