“A monkey hitting keys at random on a typewriter keyboard for an infinite amount of time will almost surely type a given text, such as the complete works of William Shakespeare”. – The infinite monkey theorem by Félix Édouard Justin Émile Borel, Mathematician
Written by Steve Nyvik, BBA, MBA, CIM, CFP, R.F.P. Financial Planner and Portfolio Manager, Lycos Asset Management Inc.
It is commonly thought that most investment managers underperform the stock market index. But is this true? And if not true, what are the implications to your investing?
What is a Stock Market Index?
A Stock Market Index can provide you with a view of how the stock market is performing. Where the index is capitalization-weighted, as most market indexes are, you’ll get a snapshot of how the market value of all companies listed is changing through time. Stock indexes are updated constantly throughout the trading day to provide instant information, and they provide historical data on the market going back decades.
Capitalization-weighted refers to a company’s value as reflected by the current market price per share of its stock multiplied by the number of its shares outstanding. The impact of an individual stock’s price change on an index is proportional to the company’s overall market value; the higher its overall market value, the more influence the company has on index movements.
Stock Market Indexes are also used as a benchmark against which money managers measure their performance. They are a known quantity and can be bought and held at a low cost.
A study published March 2013 called, “An Evaluation of Alternative Equity Indices”, conducted by Andrew Clare, Nicholas Motson and Stephen Thomas from the Cass Business School at the City University in London.
The study compares a market capitalization weighed portfolio of the largest 1,000 U.S. stocks to random portfolios as if they were selected by 10 million monkeys.
The Monkey Selections
Using data on the 1,000 largest US stocks every year from 1968 to the end of 2011 they programmed a computer to simulate the stock picking abilities of ten million monkeys. More precisely, at the end of each year the computer chose, at random, a stock from the 1,000 available. This stock was then assigned a weight of 0.1%, and was then placed back in to the pool of 1,000. This process was repeated 1,000 times until the weights of all of the chosen stocks summed to 100%. This process was repeated ten million times for every year in the sample. In other words, the computer generated ten million indices where the weights were effectively chosen by monkeys.
Starting from an investment of $100 in the U.S. stock market at the start of 1968, a market capitalization weighted index would have grown to just under $5,000 by the end of 2011. Half of the monkeys produced a terminal wealth value greater than $8,700; 25% produced a terminal wealth value greater than $9,100; while 10% produced a terminal wealth value greater than $9,500. More to the point is that nearly every monkey beat the performance of the Market-cap index.
In analyzing the performance of the 10 million monkeys, they not only generate better returns but do so with less risk.
In summary, the study not only refutes the assertion of the superiority of a market capitalization index but tells us that a market-cap approach can deliver very bad relative investment results.
Why might a Stock Market Index fund be a Bad Idea
I look at a stock market similar to going to an auction house – such as Maynard’s or Sotheby’s. If you buy a stock market index that’s capitalization weighted, this is sort of like buying all of the items of that auction house that are available for sale at market value. Those items available for sale are not usually well diversified – so you might be buying a lot of items in a small number of categories. And because a stock market index is typically market weighted, you end up buying more of the highest priced auction items therefore taking more item (company) risk. When you examine the individual items you’re buying, you’ll see some crap along with some that are overly expensive for what you are getting.
In addition, the largest market-cap companies are items that everyone knows about – they tend to be well-researched and likely to have lower returns than the rest of the items.
Hopefully this has got you thinking of taking a pass on index investing. Instead, become an auction expert where you buy the best value items and buy them at good prices – or else hire someone to do this for you.