Monkey beats BSE Sensex! 5 simple lessons from random stock picking

Is stock investment a learnt skill which only experts can manage, or does luck matter more than skill? Can a monkey throwing darts at a random list of index stocks do as well as a pro?

The answer is yes and no. Expertise does matter, but random picking can also beat the indices.

To explain why, we need to take you back to August 2011, and tell you a story about two monkeys we invented - Monkey 1 and Monkey 2 - to represent 10 random stock picks from the BSE 100 index and the BSE 500. Broadly speaking, the former represents some of the biggest, and possibly better run, companies, while the latter includes many mid-caps, and this includes both big failures and potential multi-baggers. (Read about how we created two Monkey Portfolios here )

To give you the results first: Monkey 1 had handily beaten the BSE Sensex and the NSE Nifty as on 14 November 2014 - some three years and three months after a passive portfolio (that is, stocks once picked remained in portfolio) was created in his name on 19 August 2011. Rs 10 lakh of notional investment was spread equally across 10 stocks - in Monkey 1’s case, these stocks were Adani Enterprises, Bharat Forge, Dabur India, DLF, Grasim, Idea Cellular, Nestle India, Siemens India, Tata Global and Yes Bank. Monkey 1 pulled off a return of 76.3 percent as against the BSE Sensex’s 73.81 percent and the Nifty’s 73.11 percent.

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However, Monkey 2 disappointed us. He managed a mere 29.3 percent over this longish time period with his random picks from the BSE 500 - which means even keeping money in a savings bank account would have done better. His picks were: Aban Offshore, BASF India, Bombay Rayon, J&K Bank, JSW Energy, KSK Energy, Manappuram Finance, Noida Toll Bridge, Polyplex Corporation and VIP Industries.

We would be failing in our duty if we did not tell you another thing; while allocating random picks to our two Monkey Portfolios, we also took 10 of the best picks from various brokerage houses and ran it passively. The result: the expert portfolio was miles ahead of the monkeys and the two indices by registering a gain of 90.4 percent over this period. The experts had picked the following 10 stocks, most of which turned out to be winners: Axis Bank, Bajaj Auto, Bhel, Coal India, Coromandel International, Infosys, Kotak Mahindra Bank, L&T, MRF and Reliance Industries.

One more point: a year after we launched the two Monkey Portfolios, the indices were actually ahead of both of them, with the BSE Sensex gaining 9.6 percent and Nifty 10.7 percent. Our Simian dart throwers logged 6.8 percent and minus 8.37 percent. Their only consolation: the expert portfolio also failed to beat the indices. It had gained 7.9 percent - better than absolutely random picks, but not better than the market as a whole.

So what should ordinary investors conclude from all this about what to do with their money? Should they trust the markets, or the experts? Or themselves?

#1: It is not possible to beat the market all the time even for experts. But experts can prevent huge losses in a difficult market. This could be one reason why our experts beat the monkey in the difficult markets of 2011-12.

#2: Time in the market does matter - as the experts keep telling us. In the medium to long term, good companies will outperform average companies. In the short run, even bad companies can give you a big gain. So, yes, expertise does matter in the long term.

#3: A caveat, though, on experts. Experts can possibly outperform the indices when their role in determining the direction of the market is small relative to the whole universe of index stocks. In the US, mutual funds seldom beat the indices for they are the market, as I explained in an earlier article. In India, mutual funds often beat the market because their share of market capitalisation is small. Their purchases and sales do not influence the direction of the markets. The large gap between our expert portfolio’s performance and the indices can be explained this way.

#4: Random picks from a smaller group of large-cap stocks and less volatile companies can sometimes measure up to the indices - and even beat them. This is the secret of Monkey 1’s record of beating both the Sensex and the Nifty. He picked good stocks and held on to them. He did well. This shows that if you pick fundamentally sound stocks, and hold of to them through adverse periods, you can do well. If ordinary investors want to try their hand directly in the markets and not opt for mutual funds, they should pick, say, four or five blue chip stocks from the Sensex, Nifty or even the BSE index. This does not require too much homework. But they have to stay with their picks till the market sees a secular uptrend to gain from this random selection.

#5: Random picks from a volatile group of thinly-traded stocks can be risky. This is what did Monkey 2 in. Monkey 2 needed a lot more luck to do better, but he ran out of it. If you want larger than market returns, you have to take greater risks, and here you should trust the experts. For example, you could invest in mid-cap funds. It would be risky even then, but at least you know that experts who understand risk better are handling your money.

The real takeout: Expertise and stock selection matter. So does time in the market. But luck is not an insignificant issue. The timing of your entry into and exit from the market also matters to your final returns. At different points of time, you could have different winners. As they say, Allah meherban to Gadha pehelwan (if luck is on your side, even a donkey can win). In our case, it was a monkey.

(To understand how our Monkeys picked their stocks randomly read this piece from 20 August 2011. Here is Monkey 1's Portfolio , and here is Monkey 2's) .

(Editor’s note: This is a corrected version of our original post where we had wrongly calculated Monkey 2’s portfolio gain as just 8.9 percent, when it actually gained 29.3 percent. The error happened as we failed to account for stock splits and/or bonus issues in VIP Industries and J&K Bank. We regret the errors).