Blindfolded Monkeys & Wisdom of the Stock Market

In the investing community, it’s common knowledge that most professionally managed mutual funds underperform the stock market overall.   From an article in the Time magazine blog:

Standard & Poor’s released its latest Indices Versus Active Funds Scorecard today, and the headline result is the same one delivered by almost every study of mutual fund performance since the 1960s: Most actively managed mutual funds underperform the market. To be precise, 66.21% of actively managed domestic stock funds underperformed the S&P Composite 1500 Index in the five years from 2004 through 2008.

Let’s take a moment to fully appreciate what this means.  It means that mutual funds, headed by very smart and well-paid expert investors in posh Wall Street offices, provide a lower average return to investors than a non-thinking index fund that simply tracks the market overall.  In fact, in his popular personal finance book A Random Walk Down Wall Street, economist Burton Malkiel says 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.”

How could this be?  After all, these expert investors have MBA’s from Harvard and Wharton.  Many of them work 80+ hour weeks. Don’t their decades of training, experience and hard work count for something?  According to the data, the answer is “no.”

Newbie investors always find this surprising.  It goes against everything we’ve learned about education, diligence and expertise. We would never ask a “blindfolded monkey” to perform brain surgery, so why should we ask one to invest our life savings?

The difference is that the stock picking monkey has something going for him that the brain surgeon monkey does not: the wisdom of crowds

Those of us familiar with the wisdom of crowds find Dr. Malkiel’s findings unsurprising.  This theory, popularized by a book by James Surowiecki by the same name, states that:  “large groups of people are smarter than an elite few, no matter how brilliant—better at solving problems, fostering innovation, coming to wise decisions, even predicting the future.”  The author provides ample evidence that this counter-intuitive notion generally holds true.

I’ve been studying the wisdom of crowds for several years and believe it provides a perfect explanation of why professional investors fare so poorly.  They’re competing against the crowd.

First of all, understand that stock trading is tough because it’s a zero sum game.  It takes two individuals to make a trade happen, a buyer and a seller, and most of the time they have the same objective:  to make money.  The buyer thinks he can make more money by buying a given stock and the seller thinks he can make more money by selling it.  Of course only one of them is right.  The only way to “outsmart” the market is to know more than the guy at the other end of your trades, and that’s tough to do.

Professional investors try to know more than their adversaries, which is they employ brilliant analysts to research investment targets before they purchase their shares.  The analysts do their best, but they must rely upon the same public information that everyone else in the world can see.  Well, they could try to access non-public information like yet-to-be-released financial statements, but that’s called insider trading and would quickly land them in jail.

Martha Stewart

So on the one side of a trade we have a brilliant professional investor and his brilliant analyst, and on the other side we have the average Joe.   Even though both parties have access to the same information, isn’t the professional investor smarter?  Yes and no.

He’s probably smarter than Joe, but he’s probably not smarter than all the Joe’s.  Our professional investor isn’t just competing against one guy with a 401K on E*TRADE.  He’s competing against the crowd.

The crowd has something that even the smartest professional can never obtain:  omniscience.  Collectively, the crowd knows all there is to know about every company traded on the NYSE.  For example, someone in the crowd knows that a key executive at a publicly traded company is considering defecting to a competitor because she plays tennis every Sunday with his wife.  Someone else knows that a company’s much-heralded new product is going to be a massive failure because his local retail shop accepts pre-orders for it, and the orders just haven’t been coming in.

How could our professional investor possibly know these things?   He probably can’t.  (And by the way, buying or selling a stock based on this sort of info doesn’t count as “insider trading.”)

Not only does the crowd know all, but it also has a mechanism in place for aggregating this knowledge:  the market itself.

Markets are highly efficient information gathering tools.  If you’ve ever heard of the economics term efficient-markets hypothesis, this is exactly what it states.  Markets have an uncanny ability to aggregate the collective knowledge of a crowd and reflect that knowledge quickly and efficiently into a price.  It’s fun to watch market prices move in reaction to new information.  They usually react within seconds to new information, and sometimes even before new information is publicly released (which implies that insider trading is alive and well.)

Now you see what our professional investor is up against.  To outsmart the market he has to outsmart most of the people on the other end of his trades, and most of these people know something that he does not, or else they wouldn’t be motivated to trade in the first place.

This is why I put my money on the blindfolded monkey.

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