How’s your portfolio coming together? Dartboard or monkey?

Remember, we’re going to have a mini-investment contest to compare investment strategies. As you know, IFO’s strategy is to invest for safe and growing dividends and great CEOs. At her place in life, she judges that to be the best one for her.

What about you? Want to take a flyer and invest $5,000 in a group of high-tech stocks? Recent IPOs? “Safe” Dow stocks?

You are probably narrowing down your choices and finishing up your research. Right?

Alternatively, you could use the dartboard method. This is an old link (last update in 2001!), which seems to be associated with Business Week, so we don’t mind publishing liberal snippets from the piece below [with a little editing to update it].

In 1988 the Wall Street Journal began a contest that was inspired by Burton Malkiel’s book A Random Walk Down Wall Street. In the book, the Princeton Professor theorized that “a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.”

The Journal set out to create an entertaining contest to test Malkiel’s theory and give its readers some new investment ideas in the process. Wall Street Journal staff members typically play the role of the monkeys (the Journal listed liability insurance as one reason for not going all the way and actually using live monkeys).

     The contest began on October 4, 1988 and since then more than 100 contests were completed. Initially the contest lasted one month, but recognizing that the publication of the contest was creating a publicity effect on the pro’s stock picks, the Journal began measuring the results over a six month period beginning in 1990.

The pro’s stock picks competed against four stocks usually chosen by Journal staffers flinging darts at the Wall Street Journal stock tables, which are pasted to a board. At the end of six months, the price appreciation for the pro’s stocks and the dartboard stocks are compared (dividends are not included). The two best performing pros are invited back for the next contest and two new professionals are added.

On October 7, 1998 the Journal presented the results of the 100th dartboard contest. So who won the most contests and by how much? The pros won 61 of the 100 contests versus the darts. That’s better than the 50% that would be expected in an efficient market. On the other hand, the pros losing 39% of the time to a bunch of darts certainly could be viewed as somewhat of an embarrassment for the pros.

Additionally, the performance of the pros versus the Dow Jones Industrial Average was less impressive. The pros barely edged the DJIA by a margin of 51 to 49 contests. In other words, simply investing passively in the Dow, an investor would have beaten the picks of the pros in roughly half the contests (that is, without even considering transactions costs or taxes for taxable investors).

The pro’s picks look more impressive when the actual returns of their stocks are compared with the dartboard and DJIA returns. The pros average gain was 10.8% versus 4.5% for the darts and 6.8% for the DJIA.

Some commentators have concluded that the contest offers some proof that the pros have beaten the forces of chance. However, that conclusion is not shared by Malkiel and other academics who responded with what amounts to a collective response of “not so fast my friend.”

Researchers that have come to the defense of the darts argue that the contest has some unique circumstances that deserve elaboration. It can easily be argued that the contest itself and the rules of the contest tilt the odds in the pro’s favor. In fact, the academics seem to argue that it’s not the darts that are on the losing end. Rather, they argue that investors that buy the pro’s recommended stocks are “naïve” and that those investors are acting on nothing more than “noise.”

Professor Malkiel suggests to Investor Home that the pros advantage effectively disappears if you (1) account for the fact that the pros pick relatively riskier stocks and (2) measure returns from the day after the column appears (thereby eliminating the announcement effect).

There have been several thorough studies that analyzed the contest in detail. In “The Dartboard Column: Second-Hand Information and Price Pressure,” Brad Barber and Douglas Loeffler (Journal of Financial and Quantitative Analysis, June 1993) came to some interesting conclusions.

Two days following publication, the pro picks had average abnormal returns of 4%. However, those returns partially reversed within 25 days. They also found that the pros picked stocks with (1) lower dividends, (2) higher historic and projected EPS growth, and (3) slightly higher PE ratios and betas.

Professor Bing Liang studied the contest over an even longer period and published a paper in the January 1999 issue of the Journal of Business. Liang concluded that the pros neither outperformed the market nor the darts. According to him, the pros’ supposed superior performance could be explained by the small sample size, the announcement effect, and the missing dividend yields.

One of the strongest criticisms of the contest is the fact that the Journal measures performance by price appreciation only, despite the fact that total return is measured by both price appreciation and dividends. For the period that Liang studied, the pro’s stocks had an average dividend yield of 1.2% versus yields for the darts of 2.3% and 3.1% for the DJIA average.

An additional study reached similar conclusions to those of Liang but focused on market maker activity and the bid-ask spread around the column publication. They concluded “that the column generates temporary price pressure by increasing noise (i.e., uninformed) trading from its readers.”

A dartboard scenario that is entertaining to imagine and might balance the odds would be to announce the eight stock picks, but not to disclose who made them until the contest was over. Imagine the confusion that would be created if the Journal just listed the eight picks with eight blurbs (four from the pros and four blurbs either made-up or submitted by individuals).

Another potentially humorous scenario that might test investor’s reactions to the column would be to identify the individual darts. Perhaps the same dart is consistently picking the best performers. If dart #3 for instance, picks several winners in a row, perhaps investors would start buying dart #3 stock picks on publication day in addition to the stock picks of hot pros.

Some of these scenarios are obviously offered in jest, but perhaps it’s a good time for a change. Since the academics suggest that a primary conclusion of the current contest is that naïve investors follow the pro’s picks, maybe changing the rules isn’t such a bad idea.

After all, we are talking about a contest that originated from what was initially considered by many people to be an absurd theory – that a primate could pick stocks as well as intelligent, well educated, and highly compensated investment professionals.

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About InvestingforOne

I've been investing in various assets by myself using a discount broker for many years. Over that time, I've developed some theories that others might find useful. Plus, there is more to investing than money. Time, talent, work, friends, family all go into developing a good and satisfactory strategy.
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