Burton Malkiel, a strong believer in the efficient market hypothesis, and known for his book “A Random Walk Down Wall Street” wrote 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.” Based on this remark The Wall Street Journal started a dartboard contest in 1988 to see if professionals could beat the performance of a random basket. The experiment was stopped in 2002. While the Wall Street Journal didn’t declare a formal winner research indicates that the professionals were unable to deliver higher risk adjusted returns than the random basket.

At first sight this seems to support the notion of efficient markets where professionals are unable to generate excess risk adjusted returns. Ironically the outperformance of the darts versus the professionals (and also the S&P 500 index) support the view that markets are in fact not efficient.

The reason is that buying a random basket with equal weighted positions is a strategy that outperforms in an inefficient market. An overvalued stock has by definition a higher market capitalization than it should have while an undervalued stock has a lower market capitalization than it should have. If you buy stocks based on market capitalization you will automatically buy relative more of the overvalued stock and less of the undervalued stock. If you assume that mispricings will be corrected in time the random basket is expected to outperform the market cap weighted basket.

The WSJ experiment is of course not very scientifically robust with regards to evaluating the possible alpha of an equal-weighted strategy, but a recent paper titled “Why Does an Equal-Weighted Portfolio Outperform Value- and Price-Weighted Portfolios?” provides stronger proof. The equally weighted portfolio does not have the same risk as a market cap weighted portfolio, because it invests more in smaller and riskier companies. But also after adjusting for such differences there is alpha:

The higher systematic return of the equal-weighted portfolio arises from its higher exposure to the market, size, and value factors. The higher alpha of the equal-weighted portfolio arises from the monthly rebalancing required to maintain equal weights, which is a contrarian strategy that exploits reversal in stock returns; thus, alpha depends only on the monthly rebalancing and not on the choice of initial weights.

So my suggestion for an updated version of Burton Malkiel’s statement: “a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do better than one carefully selected by experts.”

One caveat: just because monkeys were great investors in the past doesn’t have to mean that this is also going to be true in the future. A key assumption in using an equally weighted portfolio is that there is no systematic mispricing based on the ‘intrinsic value’ market cap. If small companies as a group are overvalued you would actually be hurt if valuations reverse to fair value since you are overweight small companies with an equal weighted portfolio. If equal weighted portfolio’s or ETF’s gain in popularity this is exactly what could happen, and maybe already is happening.

Disclosure

No position in monkeys, and no intention to initiate one