A Cat's Random Stock Picks Surpass Wall Street Returns by 226%
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My experience in finance over the past 18 years has led me to the conclusion that investing in actively managed funds is not a wise use of my money.
I've transitioned to investing in index ETFs, which are entirely passively managed yet still manage to outperform a majority of professional funds.
It’s astounding that 88% of fund managers in the U.S. fail to beat the S&P 500, with 92% of European funds underperforming the S&P 350 Europe.
I find it perplexing how large fund managers rationalize their fees. It’s hard to understand why investors continue to pour money into actively managed funds instead of opting for index ETFs or even randomly selecting stocks!
You could even have my cat, Bunbun, pick your stocks, and she might outperform those professional fund managers—despite lacking any formal training.
> Bunbun, a two-year-old cat, has quite a remarkable backstory. We found her as a tiny kitten, abandoned and navigating traffic on one of the busiest streets in Hong Kong, while we were in a taxi.
Prepare to be amazed by her transformation from a defenseless kitten into a savvy stock investor—her skills are truly impressive.
How We Randomly Select Stocks
To assist Bunbun in her stock selection, I developed a spreadsheet simulator that randomly chooses 5 stocks from a pool of 3,524 listed on the New York Stock Exchange.
The simulator then generates a performance chart for each stock, alongside another chart that compares the random portfolio's results to the S&P 500 over a five-year span.
I’ll guide you on how to try this yourself later, but first, let’s review the astonishing results. I will also delve into the cognitive biases and mathematical principles that explain how entirely random portfolios can significantly outperform traditional benchmarks.
Bunbun, time to press the button!
Random Portfolio 1: 173% Return
Unbelievably, the first random portfolio that Bunbun generated achieved a 173% return over the five-year period, more than tripling our benchmark, the S&P 500, which only returned 50%.
Here are the 5 stocks that were randomly selected. Notably, these stocks aren’t typically the most sought after:
The performance of this initial portfolio is impressive. The left chart displays the 5 random companies along with the S&P 500 (SPY) in navy blue, while the right chart illustrates the portfolio's performance:
Impressive, right? Is it merely luck, or can we replicate this success?
Random Portfolio 2: 43% Return
The second random portfolio produced by Bunbun's tool returned a modest 43%, underperforming the index.
It seems that the Bank of New York Mellon might have influenced the portfolio's returns.
The stocks chosen can perform exceptionally well, average, or poorly. Thus, the return distribution of our random portfolios resembles a convex curve.
As shown in the chart below, this portfolio's performance was relatively close to the SPY average:
Can you do better with the next picks, Bunbun?
Random Portfolio 3: 226% Return!
Well done, little one! Achieving a 226% return compared to the S&P 500's 50% is an incredible outcome.
If my cat were managing a Wall Street fund, she’d be in line for a substantial end-of-year bonus—potentially around $1 million. However, since she’s just a cat and the stocks were selected at random, her reward will be a tiny fish treat.
Two of the five selected stocks performed exceptionally well: Howmet Aerospace surged by 205% and Tesla skyrocketed by 855% over the five years.
This performance significantly boosts the total portfolio return:
I think it’s time to promote this kitten to Senior Portfolio Manager!
Now, let's take our random stock simulations further and analyze 10 portfolios to see how they fare.
Simulating 10 Randomly Generated Portfolios
We conducted a simulation that generated 10 random portfolios, comparing their returns against the S&P 500 index. Surprisingly, 6 out of the 10 portfolios outperformed the index, with the average return across all 10 portfolios being 92%.
Remember, only 20% of professional fund managers outperform the S&P index, yet 60% of our completely random portfolios did:
This leads to some intriguing questions:
Can randomly selected portfolios consistently outperform the market index and Wall Street funds?
How do random portfolios achieve such strong performance?
The two main reasons are:
- Randomness eliminates mental biases.
- Mathematically, increased randomness results in a greater divergence from the average.
A randomly structured convex payoff doesn’t require frequent correct choices since the upside potential exceeds the average.
I plan to write another article elaborating on the mathematical principles behind why random portfolios outperform the average, touching on concepts like the law of large numbers, convex functions, and Jensen’s Inequality.
For now, let’s explore the psychological aspect.
Why Does My Cat’s Random Portfolio Excel Compared to Wall Street Funds?
Behavioral biases help explain why a portfolio selected at random by my cat performs better. Random portfolios are inherently the least biased portfolios one can create.
Awareness of these five biases can enhance your investment strategy:
#### 1. Herd Mentality
- Fund managers often feel compelled to invest in popular stocks that may offer lower growth potential. The phrase "Nobody Gets Fired For Buying IBM" epitomizes this mentality. It should be updated to, "Nobody Gets Fired For Buying IBM, but they should."
- Conversely, lesser-known stocks may yield better results as they are often overlooked by analysts, a phenomenon known as the Neglected Firm Effect. Our random portfolio includes such lesser-known stocks that have performed exceptionally.
#### 2. Loss Aversion
- Loss aversion can hinder investors from seizing potential opportunities due to excessive caution. As Omar Aguilar, CEO of Charles Schwab Asset Management, stated, "Investors prioritize avoiding losses over pursuing gains."
- A randomly generated portfolio avoids this bias as it does not involve active decision-making.
#### 3. Anchoring
- Professional fund managers may "anchor" themselves to specific information or analyses regarding a stock or sector. Charlie Munger describes this as the liking/loving tendency: individuals often invest in companies or sectors they personally favor.
- To mitigate this bias, one must recognize that anchoring can distort rational judgment.
#### 4. Doubt-Avoidance Tendency
- Fund managers often adhere to conventional wisdom and accepted opinions, such as Modern Portfolio Theory and the 60/40 portfolio, leading to a lack of contrarian thinking that could uncover opportunities that random portfolios might exploit.
- To achieve success, being a contrarian is often essential.
#### 5. Overconfidence Tendency
- Overconfidence can lead fund managers to engage in excessive trading or frequent buying/selling of stocks, resulting in an illusion of control and suboptimal choices.
- In contrast, our randomly selected portfolio was simply held for five years, akin to what Sleeping Beauty would do.
In essence, by eliminating human emotion and enhancing randomness, we boost our investment profitability and portfolio potential.
Try My Random Stock Portfolio Simulator!
If you’re interested in experimenting with my random portfolio tool, here’s how:
- Access my Random Stock Portfolio Simulator Google spreadsheet. You may need to request access, but I will approve it promptly.
- The initial box with stocks will generate the random selections.
- Copy and paste these stocks into the designated yellow box, using "paste special" and "values only." Refer to the screenshot below.
- After pasting, data collection and chart updates may take up to 20 seconds.
- The two random stock pickers on the right do not generate charts but provide immediate performance feedback.
Conclusion
While not always accurate, a random portfolio can outperform the average due to convex payoffs that deviate from averages and the influence of mental biases. I will certainly explore this further in my next article.
It’s important to clarify that I do not advocate for a purely random approach to investing—my aim is to highlight the significance of recognizing behavioral biases and the potential advantages of incorporating randomness into investment strategies.
By grasping these concepts and utilizing my Random Stock Portfolio Simulator, you can gain insights into how randomness enhances a portfolio and become a more effective investor.
— Henrique Centieiro
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