Three years ago I had this idea to show how hard it is to successfully pick individual stocks by having a contest between investing “experts” and a stock-picking monkey.  The monkey was represented by a random selection of stocks from the S&P 500.  I expected that the random monkey portfolio would perform as well or better than the portfolios recommended by some of the world’s stock “experts” back in May of 2018.

But the stock market has a funny way of making us look like fools.  (If the stock market hasn’t yet fooled you one way or another, then it’s likely only a matter of time before that story changes.)  After an explosive start out of the gate, the monkey portfolio was significantly lagging the expert’s picks by the two-year mark of the contest.

At that time, I decided that my contest would never definitely prove that stock picking is a loser’s game.  That’s because if you compare almost any two stock portfolios, their relative performance will usually ebb and flow over time.  Examples include the varying relative performance among stock sectors, geographic areas, and investing factors like size, quality, and value.

So, it’s not surprising that my monkey looked like a winner in the first year, then a loser in the second year.  I almost decided to stop the contest entirely.  But after looking at the third year’s results, I noticed that they illustrate how the fickle market gods will always test, sometimes mightily, our convictions about any particular stock portfolio.

Contest Results – Year Three

But before I get too philosophical, I should present the contest results as of the third-year mark, which was the end of May 2021.  If you want more details about the contest and the stocks that make up each portfolio, you can read the original post.  In summary, the contestants include three portfolios selected in May 2018:

• 30 stocks recommended by Morgan Stanley
• 20 stocks favored by several hedge funds.
• 10 S&P 500 stocks randomly selected by my monkey.

And for added context, I’ve also compared the results to simply holding a low-cost index fund of the S&P 500.

Here’s a bar graph showing the annualized returns (Compound Annual Growth Rate; CAGR) for these four portfolios since the start of June 2018.

While the monkey portfolio is again the clear laggard, its nearly 16% annualized return seems pretty good for a monkey.

The Monkey Portfolio in Perspective

The decent performance of the monkey portfolio made me wonder how it compared to other popular investing themes.  I ran the same numbers for the same period for different sizes of stocks, value stocks, and the old faithful portfolio consisting of 60% stocks (U.S. large caps) and 40% bonds (U.S. 10-Year Treasury Bond).  I was particularly interested in the size and value factors because I’ve seen quite a few articles recently trumpeting the comeback of these factors after many years of poor performance.  Here’s the graph of the results.

Note that many of these portfolios (except the 60/40) aren’t realistic because they’re 100% concentrated in one or two factors.  In reality, most factor investors hold portfolios that “tilt” towards these factors, where size or value-focused funds represent less than half of the entire portfolio.  However, looking at these extreme portfolios helps illustrate whether such factor bets would help or hinder a larger portfolio with substantial allocations to more traditional stock or bond funds.

Somewhat surprisingly, the random monkey portfolio was the third-best performer among this group, beating out concentrated bets on small caps, small-cap value, and large-cap value as well as the 60/40 portfolio.  So, even though the small-cap and value factors have sprinted spectacularly in the last year, they still haven’t taken the lead in this three-year race.

Why The “Experts” Are Winning

My comparisons to portfolios that weren’t in the original contest may seem like a deflection from the remarkable performance of the two expert portfolios.  So, I should reiterate that the Morgan Stanley and Hedge Fund picks in the first graph above outperformed all the portfolios in the second graph.  Should we then conclude that these high-powered firms have some special investing mojo?  Probably not.

For one thing, I pointed out last year that most of the mojo within the expert portfolios is coming from large exposures to the so-called FAANG stocks, which are Facebook, Apple, Amazon, Netflix, and Google.  FAANG stocks have been one of the most popular and obvious stock plays for the last decade.  While the experts still had to decide whether the popularity of the FAANG stocks was justified, they clearly weren’t finding hidden gems.

I’d go even further and say that favoring FAANG stocks has more to do with cognitive biases like the bandwagon effect, recency bias, and confirmation bias.  That is, the expert portfolios involve lucky outcomes from flawed human decisions as much as savvy predictions of future stock returns.  For example, the COVID pandemic presented an ideal environment for FAANG stocks, but I’m certain none of the analysts involved picked the FAANGs because they expected an imminent pandemic.

Lucky Humans

To illustrate the importance of the lucky FAANG stock picks, let’s suppose that back in 2018 my monkey was actually only half-monkey, with the other half being human, like the Hindu god Hanuman pictured at the top of this post.  In this case, his monkey half would be making truly random uninformed picks.  But, like all us humans, his other half would be highly susceptible to exciting but anecdotal features of the FAANG stocks including: the FAANGs are well known, they’re prevalent and useful in most of our daily lives, they’ve done well recently, they have tons of positive buzz, etc.

To represent the Hanuman portfolio I added the five FAANG stocks to the original 10 monkey stock picks, and then weighted the portfolio such that the FAANGs made up 25% of the portfolio and the remaining stocks made up 75%.  This equals the weighting of the five FAANGs out of the total of 20 stocks in the Hedge Fund Portfolio.  Here’s a graph showing the three-year results for the expert portfolios, the monkey/FAANG portfolio, and a portfolio of just the five FAANGs (equally-weighted).

The FAANG-only portfolio result shows why these five stocks were such good (lucky) picks.  But it also shows that the monkey/FAANG approach would have been neck-and-neck with the Hedge Fund Portfolio.

However, the Morgan Stanley portfolio performed even better, despite having a total of 30 stocks, which causes a lower weighting toward the FAANG stocks.  So, I’m willing to admit that there’s some evidence of investing mojo at Morgan Stanley given it had 25 other picks that collectively helped beat the Hedge Fund portfolio by about 3 percentage points.  On the other hand, Morgan Stanley would now look truly brilliant if they had instead recommended betting the farm on just the FAANGs back in 2018.

Conclusions

I have no new conclusions since last year.  The contest is still kind of fun, but I don’t think it’s pointing out anything particularly new or different after three years.  To me, the contest results indicate that picking individual stocks may not be entirely a “losers game” because all three of the original portfolios have performed remarkably well over the last three years.  But with each passing year, the contest seems to show with ever greater clarity that picking individual stocks is simply a game of luck.