Scott Woolley

"Monkey Business"

"At first glance, the professional money managers seem to be providing real value to their followers. On closer examination, it seems that buying their favorites is no better than throwing darts," writes Woolley. If the pros can't beat the market, then index funds that provide the market return become a prudent proposition for investors.

Woolley evaluates the "Investment Dartboard" column of the Wall Street Journal that derived its name from Burton Malkiel's (Professor of Economics at Princeton University) famous words, "Even a dart-throwing chimpanzee can select a portfolio that performs as well as one carefully selected by the experts." The column pits investment pros against a random portfolio selected by throwing darts at the securities pages of the journal.

Prof. Malkiel's assertion seems to be challenged by the fact that the expert stock pickers featured in the column have consistently beaten the market for the last 10 years. They have notched up a 11.1% average six-month gain since 1990 compared with 7% for the Dow Industrials and 4.5% for the randomly selected portfolios.

But Woolley says that a recent study by Bing Liang of Case Western Reserve University in the University of Chicago's Journal of Business (click here to subscribe) reveals that "you can't take this outperformance to the bank." It shows that readers buying on the pros' picks would have made just 8.2% on average for a six-month holding period. Brokerage fees further reduce this return. The study also claims that the pros' higher returns are gained largely by picking riskier stocks.

The study found that there was abnormally high trading volume in the recommended stocks even before the column came out. This meant that investors were buying in anticipation of the boost the stocks get after the column is published. Most of the post-announcement gains though were wiped out within a month. " . . . the little guy, who tends to buy during the middle of the day of publication, winds up on the short end of the stick," writes Woolley.

Since the pros were competing against one another to return for the next column, they had plenty of incentive to pick riskier stocks (higher standard deviation). Liang's study shows that, adjusted for risk, the pros' picks underperform the market by almost 4%.

Even Prof. Malkiel said that the Investment Dartboard isn't a fair test of the efficient-market theory because of the small number of stocks involved and because a "publicity effect" might make the stocks selected for the contest perform better than others, at least temporarily. He also noted that the pros tend to pick stocks that are riskier than the market as a whole, which may boost their return in the short term.

If the pros can't beat the market average then investors are wasting their valuable dollars by investing in mutual funds that charge high asset management fees. A better alternative would be to invest in low-cost, tax-efficient index funds that provide the market return.

Review By Rahul Seksaria, Assistant Editor