Read time: 8 minutes
🥜In A Nutshell:
S&P 500 is a trading strategy which weighs components by market capitalization
Random equal-weighted portfolios beatmarket-cap-weighted index
Small cap companies outperform in the long run
Take a look at the performance of a secret stock picking wizard’s portfolio below . This plot shows the growth of $1 invested in the portfolio strategy (blue) from 1996 to 2024 compared to the S&P 500 index (red). The portfolio achieved a cumulative return of over 2000% meaning if you invested $1 with this money manager in 1996, you would now have $21.15 (without dividends). Over that same time period the S&P 500 index only increased roughly 750% (turning $1 in in 1996 into $8.48 now, without dividends).
Pretty huge difference! You may wonder who can take credit for this incredible performance: a seasoned Wall Street portfolio manager? A hedge fund quant trader with sophisticated light-speed strategies? Not quite... What if we told you this mysterious portfolio is completely constructed by arandommonkeypicking random stocks?
🙈 What's All This Monkey Business About?
Have you ever heard the notion that a blindfolded monkey might be better than professional stock pickers? This isn’t a setup for a joke, but a real theory floated by Professor Burton Malkiel in his 1973 book, A Random Walk Down Wall Street. [1]
Malkiel famously suggested that a monkey, blindfolded and throwing darts 🎯 at the financial pages of a newspaper, could select a portfolio that would perform just as well as one meticulously crafted by the experts. Wild, right?
This crazy idea isn't just for laughs—it challenges fundamental beliefs about the stock market and whether all the expert analysis and gut intuition can really outperform random chance. So, inspired by this theory, we've decided to put it to the test with some money managing monkeys.
🐵Simple Steps to Build a Monkey Portfolio
In order not to force any real monkey as labor, we simply simulate the random monkey portfolio with the following steps:
Fetch a complete list of all S&P 500 stock components from 1996 to 2024.
Randomly select 30 stocks of the first year (1996) from the list as our initial equal-weighted portfolio, calculate the annual return.
For every next year, repeat the random selection of 30 stocks and the calculation of annual returns.
Calculate the cumulative return and compounded annual growth rate (CAGR) of the portfolio from 1996 to 2024 and compare with the S&P 500 index (as in our graph above).
Clearly our mathematical money manager wasn’t just monkeying around: the random stocks outperformed the S&P 500 without any financial knowledge!
At this point, you might come up with a smart doubt: what if this monkey was just lucky? What if it just happened to pick the outperforming stocks at the right time? Like winning a lottery!
Nope! This cheeky monkey has an edge, beyond pure luck, by competing against the market-cap-weighted index with a simple equal-weighted portfolio.
🐒🐒🐒 Monkey See, 1000 Monkey Managers Do!
If one monkey cannot convince you, let’s see how 1000 monkey portfolios performed over the years!
In the next step, we simply repeated the above simulation 1000 times and gathered all the compounded annual growth rates (CAGR, key indicator of long-term portfolio performance). Then, we plot the distribution of results as a histogram and compared with S&P 500 CAGR as shown in the graph below.
In this graph, the horizontal axis indicates the CAGR levels (annualized performance), and the vertical axis shows how many monkey portfolios achieved each CAGR level.
The red line is the S&P 500 index’s CAGR of 8%, which is merely at the 1st percentile of the whole distribution — that means 99% of the monkeys beat the index!
The green line is the median CAGR of 11.7% among all 1000 monkey portfolios — that means 50% of monkeys did worse than 11.7% and 50% of monkeys did better.
Fun fact is, that one portfolio shown at the beginning was below the median level (with a CAGR of 11.1%)!
Equal Weighted vs. Market Cap Weighted Portfolio
Now that 99% of monkey portfolios outperformed the S&P 500 index, we see there is obviously an edge in our monkey strategy. The secret lies not in the stocks we pick, but simply in how we construct the portfolio — how we weigh the components of each stock.
While we often refer to the S&P 500 index as “the market” as though it is a fixed entity, the S&P 500 index is actually a trading strategy with each stock component weighed by its market capitalization.
Large cap companies have much more influence on the index than small cap companies, e.g., the “Big 7” hold about 27.5% of the index’s total weight — more than a quarter!
In contrast, our random monkey portfolios hold all components as equal weights, no matter the largest cap or the one far down the list; no one dominates the others!
The portfolios’ outperformance shown in the results supports the edge of small cap companies — small companies have more potential for growth, more volatility, and less analyst eyeballs that all result in a long-term edge. Large caps companies run up against limits of growth, and it becomes harder and harder to move the needle.
As we saw in 📖Stop Checking The Price! searching high-quality small caps presents hidden pearls amongst the large cap waves. So thanks to the blindfolded dart-throwing stock picking monkeys out there that remind us beating “the market” is not all monkey business.
Bottom Line:Small companies outperform in the long run!
References:
Malkiel, Burton Gordon. A Random Walk down Wall Street. Norton, 1973.
Arnott, Robert D., et al. “The Surprising Alpha from Malkiel’s Monkey and Upside-down Strategies.” The Journal of Portfolio Management, Vol. 39, No. 4, 31 July 2013, pp. 91–105.
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