In “A Random Walk Down Wall Street” Princeton University professor Burton Malkiel claimed that a blindfolded monkey could do as well as the professional traders in selecting an investment portfolio. This theory was put to the test by Research Affiliates where they randomly selected 100 portfolios of each containing 30 stocks over a period of 1964 to 2010. This stimulated the “monkeys” randomly picking their stocks. The result was that these randomly selected portfolios outperformed the market index by 1.7%, hence beating the “professional” traders. The “monkeys” not only performed as well as the traders, but they also beat them! That might be an excellent endorsement for getting a monkey to deal with your financial investments from now on! Before you do, however, you might need to continue reading.
Smaller Stock is Both Riskier & More Rewarding
In analysing the results of the experiment, the researchers found that the reason why the “monkeys” outperformed the traders was mostly due to inclusion of smaller stocks as in stocks for lesser-known brands than the usual global stocks. When people select stock, they rely on a more significant portion of investing in larger, well-known companies.
When chosen randomly and without the knowledge of which stock belongs to which big brand, the portfolios contained a more significant proportion of smaller stocks. Herein lies the connection with outperforming the index. As smaller stocks have higher yields, they also have a higher risk profile. Where larger companies can be relied on for continued business and stability, the yields will be lower.
Smaller stocks don’t have that security and therefore will deliver better value when they pay off. In short, in selecting a riskier portfolio for the years between 1964 and 2010, an investor would have beaten the regular market returns by 1.7% on average.
Our Own Bias
The “monkeys” randomly selecting stock is a great way at looking at your own investment behaviour and will give away what kind of risk profile you should take on when investing. If you can afford it and are looking for bigger yields, you should be willing to take risks. When you are risk-averse, you should pick larger stocks of well-known brands or invest in bonds altogether.
This all seems quite straightforward, but the issue is that we mostly live in a bubble of our own making. What’s a low-risk portfolio for you might be something of extreme risk for another. It’s essential to be able to take a few steps back and put everything in perspective. What’s important to consider is that some of these risk-appetite is culturally defined. FreeBets has a great infographic showing you which countries bet the most. And you can take betting as an indicator of who is willing to endure a more significant risk appetite.
Take this into consideration and taking the emotion out of investing (i.e. don’t invest in a company just because you like their products) will serve you well in creating a better portfolio. That’s not to say that you can’t make moral choices to not invest in things you consider unsustainable companies such as oil and weapons manufacturing. Actually, environmentally & positive sustainability companies have shown great returns in the last few years, so it makes great investment sense.
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