The Wall Street Journal’s Dartboard Contest

Meet Your New Money Manager

Economist Burton Malkiel, author of A Random Walk Down Wall Street held that because financial markets are “informationally efficient,” an investor can’t consistently achieve returns in excess of average market returns on a risk-adjusted basis. He drove the point home with the contention that that even a blindfolded monkey throwing darts could do as good a job in picking stocks as a professional money manager.

Game On

The Wall Street Journal created it’s famous Dartboard Contest in 1988 to test the theory. The Journal made random stock picks and compared these to picks by investment experts as well as those of readers, and, in 1998 published the results of the 100th dartboard contest.

Results: Not Very Impressive

The results appear to show that nobody’s really able to consistently outperform the market:

  • The experts beat the monkeys only 61% of the time.
  • The experts essentially tied the Dow Jones Average (51% record.)
  • The experts’ average return was just 10.8% compared to 6.8% for the Dow and 4.5% for the random picks.

Is Index Investing The Answer?

The contest appears to show that – even without factoring in taxes, management fees, and the low likelihood of outperforming the benchmark indexes,  an investor should be able to outperform professional money managers about half the time only by investing the Dow Jones Industrial Average.

The major advantages of index investments, according to Money Crashers:

  1. Markets Are Efficient. The indexer basically believes that the market as a whole is very good at quickly pricing all the available information about a stock or a market into the market price (i.e. efficient market hypothesis). It is therefore almost impossible for a given money manager to outguess the market consistently over a long period of time.
  2. It Is Very Difficult to Identify Winning Fund Managers in Advance. Looking at the returns of the top fund managers every year, in the majority of cases, a fund manager will outperform for a year or two, but when another investment style becomes popular, they decline. The indexer doesn’t believe it makes sense to try to guess who will be this year’s best performing manager.
  3. Mutual Fund Managers Cannot Reliably Add Value Beyond Their Costs. In the aggregate, mutual fund managers and other institutional investors cannot reliably beat the market. The reason: collectively, they are the market, and should under-perform a well-constructed index by approximately the amount of their costs.
  4. Index Funds Have Lower Turnover. It costs money to churn – or excessively trade – securities in your portfolio. Mutual funds have to pay brokers and traders, and must also absorb the hidden costs of bid-ask spreads every time they trade. The bid-ask spread is the difference between what a stock exchange market maker pays for the stock and what they sell it for. Brokerage firms identify the overlap between what investors are willing to pay for a security and what investors are willing to sell a security for, and make part of their money by pocketing the difference. The more trading a fund does, the higher these costs. But index funds never have to trade, except when new securities are added to the index, or to buy or sell just enough to cover fund flows coming in and out as investors buy or sell.
  5. Index Funds Are Tax-Efficient. Every time a mutual fund sells a holding at a profit, it must pass that profit on to its shareholders, who pay capital gains taxes on that profit (except for funds held in retirement accounts, like an IRA or a 401k.) Index funds are normally tax-efficient, due to low turnover. This isn’t relevant fbut it’s a major consideration for mutual funds held outside of retirement accounts. For this reason, index funds are popular choices for use in taxable (non-retirement) accounts.

 A Counter Argument

Warren Buffett, who is among the most successful value  investors, rejects the logic of efficient markets. He made fortunes by buying stocks at a discount to their intrinsic value. Because the efficient market theory doesn’t hold in every case, he looks for stocks that markets are pricing too low, and has been successful finding stocks selling for 30%, 40%, or even 60% off of their true worth.

The downside is that it takes a great deal of time and frequently leads to very narrow portfolios, which can mean more volatility. Investors have to decide whether they want to pay a manager a percentage to pick securities for them, or just keep the fee and invest it, rather than paying it to the manager.

How would Warren Buffet answer that objection? Well, for most people who don’t have the time and expertise to dig deeply into analysis and research, Buffet himself recommends the indexing approach.

More reading:

Monkey business – Forbes.com

Journal’s Dartboard Retires After 14 Years of Stock Picks – Wall Street Journal (Google Cache)

Investing in Index Funds vs. Managed Mutual Funds

Buffett: Index funds better for most investors – Reuters

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