For 14 years, Wall Street Journal staffers picked stocks by throwing darts at a board.
They then compared their results to the performance of top investment professionals. The professionals won, but not by much.
This retired but long-running WSJ feature came to mind when I heard Think Like a Freak coauthor Stephen Dubner tell CNBC the other day, “If you look at, let’s say, stock picking advice specifically, you find that the experts, the people that we most revere, the people that we pay the most, are generally about as good as a monkey with a dart board.”
In the WSJ feature, the darts won 55 of the 142 contests, and the pros won 87. That 61% to 39% margin would be a blow in an election, but remember: this is not just any old human vs. darts. This is the best in the business against randomness.
Soothsayers and Money Managers Performing Badly
In their new book, Dubner and his coauthor Steven Levitt cite a study by CXO Advisory Group examining 6,000 stock market predictions by so-called experts over several years. Experts’ overall accuracy rate was 47.4%.
“Again, the dart-throwing chimp likely would have done just as well—and, when you consider investment fees, at a fraction of the cost.”
Beyond those just making predictions to those who actually manage money, Charles Hugh-Smith makes the provocative claim that “The entire financial management industry is a profit-skimming rentier arrangement.” He wrote that less than half a percent of mutual fund managers outperform the S&P 500 over 10 years.
Indeed, according to the Wall Street Journal’s online screening tool, only 71 of 17,785 funds—just 0.4%—outperformed the S&P over 10 years.
In the latest summer edition of WSJ Money, Brett Arends writes of randomly picking stocks from the top 3,000 listed companies in the world. His portfolio tripled in 10 years and beat all but six funds. He carefully points out this was not an index fund, but “the proverbial portfolio picked by a blindfolded monkey.”
Arends adds that a portfolio of 80% randomly selected stocks and 20% Treasury bills will “make a lot of money managers look pretty bad.”
But experts keep right on predicting and money managers keep on managing… badly. When asked to name the attributes of experts who make bad predictions, psychology professor Philip Tetlock replied, “Dogmatism.” Tetlock says pundits are “massively overconfident” even when they’re wrong.
The authors equate the worlds of politics and business to a warm and moist environment that breeds deadly bacteria. “Their long time frames, complex outcomes, and murky cause and effect are conducive to the spread of half-cocked guesses posing as fact.”
Plus, there’s only upside in making a bold prediction. If you’re right, you can brag about it for years. Think Elaine Garzarelli, who called the 1987 crash, but little since.
And if you’re wrong, everyone forgets. It doesn’t cost you a thing. I remember a finance professor in college telling our class, “Predict often; every so often you’ll get lucky and be right.”
But the question remains: fund managers and market analysts work countless hours with the sole purpose of beating the market. Why are only a tiny few able to perform?
Too Easily Deceived, Looking for Patterns
Freakonomics authors Dubner and Levitt spoke with magician Alex Stone about fooling kids versus adults. Adults are easy to fool, he says, and scientists are especially easy. But kids catch his deceptions all the time.
“Every magician will tell you the same thing,” Stone says. He cites several reasons: adults are vulnerable because they are used to following directions, so the magician can lead them to see what he wants them to see. Kids lack focus with their attention, “which makes them harder to fool.”
Adults carry assumptions and expectations based on their memories and experience, while kids are “relatively free of assumptions and expectations about how the world works.” Also, kids are naturally curious, trying to figure out how the world works. And they don’t tend to overthink a trick as adults do.
My favorite reason of Stone’s is, “We’re getting dumber as we get older, perceptually. We just don’t notice as much after 18 or so.”
Skeptic Michael Shermer adds that patternicity, “the tendency to find meaningful patterns in meaningless noise,” also hinders adults’ judgment. It’s caused by what’s known as the priming effect, “in which our brain and senses are prepared to interpret stimuli according to an expected model.”
This tendency helped humans survive in the jungle. In the market, not so much. “Unfortunately, we did not evolve a Baloney Detection Network in the brain to distinguish between true and false patterns,” writes Shermer. “We have no error-detection governor to modulate the pattern-recognition engine.”
Decision Fatigue: Why Humans Follow the Herd
Levitt and Dubner chronicle the results of a survey about conserving energy. Why did Californians do it? To save money? To protect the environment? To help future generations? Nope. The clear winner was “Join your neighbors.” Humans are herd animals. Herd behavior “influences virtually every aspect of our behavior—what we buy, where we eat, how we vote.”
And you know what? It makes sense. Who has the time or the energy to think through all of life’s decisions? If something’s good enough for everyone else, collectively they must know what they’re doing. Going with the flow helps humans deal with decision fatigue, which studies show is very real.
Experiments show that self-control and discipline are finite. “No matter how rational and high-minded you try to be, you can’t make decision after decision without paying a biological price. It’s different from ordinary physical fatigue—you’re not consciously aware of being tired—but you’re low on mental energy,” writes John Tierney, coauthor of Willpower: Rediscovering the Greatest Human Strength.
Tierney’s coauthor Roy Baumeister says, “Good decision making is not a trait of the person, in the sense that it’s always there. It’s a state that fluctuates.”
Tierney also points out that “Shopping can be especially tiring for the poor, who have to struggle continually with trade-offs.” Researchers argue that decision fatigue traps people in poverty. The constant mental strain of figuring how out to stretch limited resources saps them of their willpower, and they succumb to impulse purchases that waste money and lead to obesity.
Imagine what that’s like for money managers. They go shopping every day the market is open, with their and their customers’ livelihoods hanging in the balance. Money managers have a finite amount of capital to deploy and must weigh trade-offs carefully. They are judged critically quarter to quarter. The end of the quarter tempts them to sweeten their holdings, just as the poor are tempted by candy at the cash register.
Stress: The Great Limiter
Even the best investors are stressed out by losses. Will one be as mentally sharp at the time one needs it most? Not likely.
For his research on stress, Nuno Sousa, a Portuguese university professor, exposed rats to all kinds of distress: he shocked them, dunked them in water, and caged them with dominant rats. He found that while stress-free rats could perform simple tasks, stressed-out rats could not. Stress changed the rats’ neural circuitry: regions of the brain associated with executive decision making and goal-directed behaviors shriveled. Brain regions linked to habit formation had bloomed.
Stanford neurobiologist Robert Sapolsky believes Sousa’s research gives us insight into why people cannot escape ruts. Dr. Sapolsky says, “We’re lousy at recognizing when our normal coping mechanisms aren’t working. Our response is usually to do it five times more, instead of thinking, maybe it’s time to try something new.”
Money Managers Are Human Too
As smart and dedicated as money managers and market pundits may be, they too get tripped up by their all-too-human frailties. Remember that when considering front-end loaded mutual funds, or when hedge fund managers want to charge you 2% of assets and another 20% on any gains.
Nobody is saying we should all throw darts to determine what to invest in. But there’s no reason to pay professional money managers to barely keep up with blindfolded chimps.