“A blindfolded monkey throwing darts at a newspaper’s financial pages could beat most experts.”
Princeton professor Burton Malkiel uttered that slam against Wall Street stock traders back in 1973.
He claimed that despite their fancy-pants degrees, professional traders can’t predict the future any better than … well … a blindfolded monkey. His book around that topic became a mega-bestseller and investing classic.
I love wagering real-life money on ridiculous experiments. One year ago, I put his statement to the test.
Well, kinda.
I had trouble finding a monkey. And I can’t train my cats to throw darts. (Grrow!)
So I blindfolded myself, flung darts at a list of stocks, and bought the first 10 that I hit.
These included Viacom, Nike, Kellogg’s, Nokia, Discovery Communications, Berkshire Hathaway, Unilever and a few more. I put $100 into each. (Check out the YouTube clip).
Fast-forward one year: What happened? And what lessons — if any — can we learn?
Don’t Wager the House
In the past 12 months, I’ve gained a grand total of …. (drumroll, please) … $57.19!
I’m rich, baby!
In all seriousness, that’s a pathetic little gain, and not just in raw dollars: $57.19 on an investment of $1,000 is a total gain of less than 6 percent.
“Hey, at least you gained instead of lost!”
While I appreciate the optimism, that’s not how you should view investments. Investing isn’t a game of playing-not-to-lose. That’s all defense; no offense.
Here’s a better mental framework:
- Opportunity Cost – What opportunities did I miss by keeping my money tied up? What’s the next best alternative?
- Risk – Does the reward reflect the risk?
- Diversification – Got it? Or not?
- Fees – Trading fees literally spell the difference between gain or loss.
Let’s check these out.
Opportunity and Risk
Pop quiz:
- You earn $100 in a savings account.
- You earn $100 investing in Enron stock.
Does $100 = $100? Are these two investments equivalent?
Nope.
Alright, second question:
- You earn 1.5% in a savings account.
- You earn 1.5% in GM stock.
Does 1.5% = 1.5%? Are these investments interchangeable?
Nope.
Contextualize your investments. In the context of risk, X does not equal X.
Wall Street pros will analyze an investment’s “risk-adjusted return,” which they calculate using a long string of Greek letters. They measure risk in five ways: alpha, beta, r-squared, standard deviation, and the Sharpe Ratio. (Unless you’re a Jeopardy contestant, you don’t need to remember that.)
“Why measure risk in five ways? Isn’t that redundant?”
Because this concept is so important that it’s worth crunching numbers from multiple angles. (It’s the same reason we use at least three formulas to crunch rental property numbers.)
You’re a normal human, not a financial professional (zing!), which means you don’t need to bother computing Greek formulas as long as you keep the concept of a risk-adjusted return in mind.
Don’t assume that X = X when one represents a Treasury bill and the other represents emerging markets.
You can’t say X = X when one represents a luxury rental in Silicon Valley and the other represents a dilapidated shack in a war zone.
“Cool, got it. But what does this have to do with your blindfolded-monkey experiment?”
As a control, I also invested $2,000 into a high-yield savings account. Those savings landed me $28.49.
The bank required $1,500 to open an account, so I simplified things by tossing $2,000 into the account. Divide by half to see how much money $1,000 would earn.
Result:
- I pocketed a virtually-risk-free $14 gain in the savings account
- I walked away with a high-risk $57 gain in stocks
— both with the same initial $1,000 investment.
“But you were certain to earn about $14 on your savings account. Heck, your principle is even FDIC-insured, the epitome of safety. By contrast, you had the POTENTIAL to earn more — or lose more — with stock investing.”
Yes. That’s correct.
And that perfectly illustrates the concept of opportunity and risk. Investments create a strange type of mathematics in which the difference between $57 and $14 does not equal $43.
The difference is far more nuanced and complex — and ultimately, the best approach is to adopt a healthy mix of both strategies.
“That’s the conclusion? All this info, and the conclusion is ‘invest in a healthy mix of both?'”
Yep. You can read nutrition blogs all day long, but you know how the story ends: “eat a healthy mix of protein, carbs and fats.” Investing is similar.
We can argue until we’re blue in the face about the “best” ratio of protein to carbs to fats (or, in the world of investing, the best ratio of savings vs. stocks vs. bonds), but the final story is still (mostly) the same.
Heap a healthy mix of the good stuff onto your plate; enjoy the results.
Speaking of mixes —
Diversification
Individual stocks (Nike, Viacom, Coca-Cola, Tesla, GM) are volatile. They could turn into either Apple or Enron.
Given that I invested in 10 individual stocks, I exposed myself to a boatload of risk and roller-coaster volatility. In the context of that level of volatility, 6 percent returns are nothing to brag about.
“But you picked 10 stocks, not just 1. Isn’t that like a mutual fund?”
Nope. Most mutual funds have hundreds, if not thousands, of stocks.
- Index funds like the S&P 500 track (you guessed it) around 500 stocks.
- The Wilshire 5000 tracks …. around 3,698 stocks. Not 5,000. Don’t ask me why.
I reduced some risk by throwing darts at big-name, established companies (known as “large-caps,”) such as Nike, Kellogg’s and Nokia.
Because these are established behemoths, they’re less likely to crash-and-crater than teeny little startups that recently debuted on the trading floor.
But let’s look at how my results compare to the broad market.
- The S&P 500, an index that measures 500 large companies traded on the NYSE and NASDAQ, gained 12.6 percent last year.
- I gained 6 percent.
- I underperformed the overall market by half. Ouch!
By investing in an index fund that tracks the overall market — like the S&P 500 — I would have lower risk and higher returns.
By investing in a handful of individual stocks, I carried higher risk and ended up with lower returns.
Does this mean you should avoid individual stocks completely? No. But it illustrates that you shouldn’t wander into individual-stock-terrain with the bulk of your portfolio.
Put a little “fun money” into individual stocks, but keep the majority of your assets (like your 401k funds) in index funds and ETFs that track the overall market.
Learn How To Escape the 9-5
Get free updates on building wealth and living to the fullest.
Zero spam.
“S&P 500 track (you guessed it) around 500 stocks”
These days it’s 502 ticker symbols thanks to weird dividend/splits from google and discovery communications! I think the google split was the first time in history it was more than 500 symbols, and when discovery wanted to do something similar they said, “aww, to hell with it. It’s already 501… make it 502!”
LOL! I saw that when I checked the Wikipedia article, which is why I wrote “around 500” … I literally laughed out loud when I saw the precise number is 502. Maybe it’s heading in the direction of the Wilshire 5000 (er, the Wilshire 3698!) 🙂
Good read. Made me realize I need to diversify my stock investing a little more. Thanks
Didn’t you also originally dollar cost average into BRK.B? I suspect that wouldve netted ~20% return on the year.
I tried to dollar-cost average into it, but I had a technical glitch, and I didn’t catch it until it was too late (it would have skewed the January-through-January nature of the experiment).
If I had started dollar-cost averaging into Berkshire, even in March, I would have had some pretty serious returns. But we only know that in hindsight, of course — there’s no way to predict how well BRK (or any other stock) would perform at the start of the year.
I started a little academic experiment of my own and have been dollar cost averaging into BRK since April. 12% average returns so far…we’ll see if it’s sustainable over a long period of time though!
That’s awesome!! Hmm, maybe I should dollar-cost average into BRK this year. It IS January, after all …
Regarding your experiment, I had been waiting with some interest for the outcome of this experiment. I read this article several weeks ago, so its fresh in my mind. Rereading it just now, it appears to have been modified. It appears you never actually set up the dollar cost averaging, and recently went back to your blog post 1 year ago, and redacted that information from the original plan in the old post?
Just a bit interesting… 🙂
@TokenReader — Yes, I had trouble setting up the dollar-cost averaging. I tried to set it up in January, but the order didn’t get pushed through, and I caught the error in late March when I checked my account. At that point, it was too late. 🙁
Your timing is interesting. I just finished Tony Robbins’ new book, Money, Mastering the Game. He shows how millionaires and billionaires set themselves up not to have much downside risk while locking in any possible upside earnings. Now there are arrangements so even us little investors can do the same. The book is well worth reading, especially for those who are young enough to pack it away for their future.
Hi Paula
Did you take into account the dividends received?
Looking at the stocks you picked I see some nice dividend growers in there.
25$ this year might very well mean 27.5$ next year or 436$ in 30 years at a growth rate of 10%. On an initial investment of 1000$.
I agree with you though that for most people out there, a broad ETF is probably the best choice.
All the best Love your blog!
This article introduced my to Loyal3.com & was worth the read for this referral alone. I went to their site & learned about their story & was SERIOUSLY impressed.
Thank you for sharing this great company find!
Best,
CP
@CP — I’m glad you like it! I discovered them about a year ago and had the same experience — I was definitely impressed. Paying transaction fees for individual stocks has always been irritating. I was thrilled to find a zero-fee way to invest. Plus, I love their mission and feel. 🙂
Love the experiment, and the diversification conclusion! My blindfolded monkey told me to hold the darts and buy a diversified basket of ETFs instead. My IRAs at TDAmeritrade, and they have a huge list of fee-free ETFs, including some really good Vanguard ones. ETFs are like mutual funds, but more nimble (I think the difference is that they’re traded on the stock market instead of separately, so it’s easier to get in and out of the ‘club.’)
Plus, of course, diversification through rental real estate 🙂
Given most of the stocks in the list, not sure what kind of great return should be expected. Easiest and cost effective route would be to just invest in an index fund such as VTSAX. Or just do Berkshire if you want to focus on the Warren moat companies. The options also beat money managers.
@Brian — If you have Vanguard funds, the optimal 3-index-fund portfolio (with no minimums) is VTSMX, VGTSX and VBMFX. I write about that in my beginner’s guide to investing: http://affordanything.com/2014/06/10/the-ultimate-beginners-guide-to-financial-awesomeness/
You explain complex concepts like risk based return easy to understand.
What are your thoughts on target date funds?
Great blog, I’m almost done reading Tony Robbins new book Money Mastery, It is a great read one of the best if not the best financial book I have ever read. You are so right diversification is key my thoughts is not to only invest in low cost index funds but also in rental property therefore you have a solid financial future. Thank you for introducing us to Loyal3. In Mr. Robbins book he also talks about investing in annuities insurance companies where you can never lose your principle and you can earn a paycheck for life . It’s like social security for investors.
Hi, I’ve been waiting for your update with real interest – thanks!
You are disappointed with your less than 6% increase (any dividends?) because the S&P 500 showed a 12.6% increase over the same period?
Had I done the same experiment with the FTSE 100 and gotten a 6% increase, I would have been happy as the FTSE 100 reported a 2.6% loss.
As I’m still only building my own portfolio, I’m going to shelve my own experiment until next year, if only to introduce some “randomness” to my portfolio (I invest mostly in trackers but have a small number of individual stocks).
Love your blog – my 22 year old daughter, just starting out with a family, is inspired by it as well.
One thing you didn’t mention though: taxes. What is the persent you’ll have to pay on savings interest earned v. the stock earnings? That will also make a difference in your net gain.
Beautifully done as always, my dear. Cracked me up every other paragraph 🙂 Though, I will say there is one company that you and I both know that would nix this part here – “That means buying/selling a basket of 10 stocks would have cost $80 to $200.” Motif! Though Loyal3 still beats out in terms of fees since it’s $0.00 cost vs what, $9 or something total for Motif?
Now to check on that monkey I ordered for your birthday..
Such a cool experiment, Paula. We are just now considering whether to sell the individual stocks purchased through our employee stock purchase plan (and drop them into our asset allocation of index funds) or to let a small percentage ride. Thanks for reminding us of the right answer: both, in proper ratios.
A savings account is, let’s say, safe, but the return on investment is really low. You got to risk if you want to win. So you’re left with the option of investing in stocks. Yes, they’re volatile and yes, they are a lot to choose from, increasing the risk of losing money. That’s way I prefer investing not in 10 but in 4 stocks with proven records. Better return than with savings, lower risk.
In holland u pay 1.2% taxes each year on the total capital u have. Also known as vermogensrendementsheffing in dutch.
While Ive got 1% of interest from my bank im losing out on the money I have.. Also inflation not to mention. Allways try to get your capital working for you!
Thats nice 0 transaction costs. degiro.nl broker im using is letting me pay 0.50 total + 0.00004 for each share that I purchase through them and thats the only cheapest broker we have here in Holland… 🙁
Oh my goodness, in Holland you pay taxes on your savings AFTER paying income tax? Wow. A national penalty on saving money and financial responsibility. That’s a shame.
Good suggestions. Learn how to identify the best risk/reward opportunities and cycles for timing. Try to be ahead of the herd.
I don’t know if you want to post this or not. I’m reading through all of your blogs and I’m up to this one. My XIRR since 2005 with individual stocks is over 17%. An easy way to invest in stocks is to go to http://www.fool.com. I’ve learned so much from that site.
Now, you might ask, if I avg over 17% annually in stocks, why do I invest in real estate? I currently have 6 units, a triplex and 3 single family homes and I’m planning to get more. It’s partly for diversification, but mainly for the fact I can leverage with RE. I can put 20% down and the bank or someone else can give me 80%. I can’t do that with stocks.
Plus, RE investing helps to save a lot of tax money.
Stock investing is easy though. Don’t throw darts. Just read the Fool.
Fool on,
Mark