Is the Monkey Model a Smart Strategy?

An interesting notion for picking stocks first proposed nearly fifty years ago, and resurrected from time to time, is that blindfolded monkeys throwing darts at pages of stock listings from Barrons can be used to “construct” portfolios that should do just as well, if not better, than both the equity markets alone and the strategies of the average professional money manager.1

If this is true based on the anecdotal evidence frequently dredged from Google searches, why might it be the case? And if so, does this model actually imply that “darting” could be an overlooked effective or reliable investing method?

The Dart Board

Exhibit 1 shows the components of the Russell 3000 Index (regarded as a good proxy for the broad U.S. stock market) as of December 31, 2016. Each stock in the index is represented by a box, and the size of each box represents the stock’s proportional market capitalization (share price multiplied by shares outstanding) or “market cap” in the composite index. For example, Apple (AAPL) is the largest box since it has the largest market cap in the index. The boxes get smaller as you move from the top to the bottom of the exhibit, from larger stocks to smaller stocks. The boxes are also color coded based on their market cap and whether they are value or growth stocks. Value stocks have lower relative prices (as measured by, for instance the price-to-book ratio) and growth stocks tend to have higher relative prices.

In the exhibit, blue represents large cap value stocks (LV), green is large cap growth stocks (LG), gray is small cap value stocks (SV), and yellow is small cap growth stocks (SG). For the purposes of this analogy you can think of Exhibit 1 as a proxy for the overall stock market and therefore similar to a portfolio that, in aggregate, professional money managers buying U.S. stocks must hold when they compete with their simian challengers (similarly limited only to only U.S. stocks). Because for every investor holding an overweight of a particular stock (relative to its market cap weighting), there must also be another investor underweighting that same stock. This means that, in aggregate, the average portfolio for money invested by the average investor–whether a professional manager or an individual investor—must look like the U.S. stock market.2 It is simply an arithmetic result that for every winner, there must be a loser before trading costs for shares are considered.

Exhibit 1 – US Stocks Sized by Market Capitalization

For illustrative purposes only. Illustration includes constituents of the Russell 3000 Index as of December 31, 2016, on a market-cap weighted basis segmented into Large Value, Large Growth, Small Value, and Small Growth. Source: Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Please see Appendix for additional information.

Exhibit 2, on the other hand, represents the dart board arrangement that the monkeys actually use to play their picking game based on the model of its proponents. Here, the boxes still represent all same stocks shown in Exhibit 1. However, instead of weighting each company by market cap, the companies in Exhibit 2 are weighted equally. For example, in this case, Apple’s box is the same size as every other company in the index regardless of its market cap. If one were to pin up pages of newspaper stock listings to throw darts at, Exhibit 2 is representative of what the individual targets would look like on their dart board.

When comparing Exhibits 1 and 2, the huge difference is obvious. In Exhibit 1, the surface area is dominated by large value and large growth (blue and green) stocks. In Exhibit 2, however, small cap value stocks dominate (gray). Why does this matter? Decades of academic research has shown that, historically over time, small company stocks have had excess returns relative to large company stocks. Research has also shown that based on the available empirical data, value (or low relative price) stocks have had excess returns relative to growth (or high relative price) stocks. We believe this is due to different underlying risk characteristics of different groupings of stocks leading to systematically larger differences in expected returns. Because Exhibit 2 has a vastly greater proportion of its surface area dedicated to small cap value stocks, it is much more likely that a larger proportion of stocks will be regularly selected randomly by dart-throwing monkeys, such that their model portfolio would be tilted towards stocks having higher expected returns compared to the U.S. market as whole.

Exhibit 2 – US Stocks Sized Equally

For illustrative purposes only. Illustration includes the constituents of the Russell 3000 Index as of December 31, 2016 on an equal-weighted basis segmented into Large Value, Large Growth, Small Value, and Small Growth. Source: Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Please see Appendix for additional information.

So…throw away?

Therefore, haphazardly selecting stocks by the toss of a dart is not an effective or even a reliable way to seriously invest the savings of a lifetime. For one thing, it ignores the complexities that arise in competitive markets. Unconcerned with the negative impact of practical trading activities, monkeys throwing darts for theoretical portfolios have a decided returns advantage compared to calculating portfolio returns of active managers impacted by direct and indirect trading costs. The Monkey Model will win in most head-to-head competitions since not only do monkeys work for bananas, but also it is not concerned (and the model does not consider) inevitable trading and market impact costs.

Consider as an example an investment strategy seemingly as straightforward as holding every stock in the Russell 3000 Index at an equal weight (the equivalent of buying the whole dart board in Exhibit 2). In order to maintain an equal weight in all 3,000 securities, an investor would have to rebalance frequently, buying shares of companies that have gone down in price and selling shares that have gone up. This is because as prices change, so will each individual holding’s respective weight in the portfolio. By not considering whether or not these frequent trades will add true value over and above the costs trading generates, investors are exposed to a potentially less than desirable outcome—more likely than not, losing all (or even more than all) the higher expected return advantages of a portfolio tilted toward small and value stocks.

Instead, if there are well-known relationships that explain differences in expected returns across stocks (such as we believe to be the case) for deciding how investment portfolios should be managed for retirement goals, using a systematic and purposeful approach that considers real-world constraints is more likely to increase the investor’s chances for greater and more reliable outcomes. Considerations for construction should include things like: understanding the true drivers of returns, how to best design a portfolio to capture them, what a sufficient level of diversification is, how to appropriately rebalance, and last but not least, how to keep the associated costs low so returns will be higher.3

Conclusion: The Long Game

So what insights can be gleaned from this modest study? First, returns of the broad market can be enhanced by tilting a portfolio towards dimensions of higher expected returns, potentially outperforming a market portfolio without futilely outguesses market prices as active managers attempt, as the old Monkey Model illustrated. Second, patience in the implementation of a selected investment policy strategy is essential. Third, unlike the Monkey Model ever considered, portfolio design, trading, diversification and rebalancing must be managed cost-effectively. Lastly, investors must focus on a framework for planning a lifetime income in order to enjoy the retirement lifestyle they need and want.

The importance of having an asset allocation aligned with objectives and risk tolerance cannot be overemphasized. Informed about the right asset allocation for your family, an experienced wealth management consultant can design the right investment strategy, using a customized process to keep your family on course as life and markets change. Even the best constructed portfolio has periods of disappointment. A CFP® professional specializing in retirement can guide you through an integrative process focused what matters for accumulating and preserving wealth for lifetime income with peace of mind, and leaving a legacy for those people and causes you care about most deeply.

Appendix

Large cap is defined as the top 90% of market cap (small cap is the bottom 10%), while value is defined as the 50% of market cap of the lowest relative price stocks (growth is the 50% of market cap of the highest relative price stocks). For educational and informational purposes only and does not constitute a recommendation of any security. The determinations of Large Value, Large Growth, Small Value, and Small Growth do not represent any determinations a firm such as Dimensional Fund Advisors may make in assessing any of the securities in the classifications shown.