Cat beats pro stock pickers

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Across the pond over in England, the Observer, sister paper of the Guardian, ran an experiment over the course of last year to see who could pick the more profitable group of stocks: professional investment managers, a group of students or a cat.

Each team had 5,000 pounds to invest in five companies from the FTSE All-Share index at the beginning of the year. Every three months, they could trade their stocks.

“The cat selected stocks by throwing his favourite toy mouse on a grid of numbers allocated to different companies,” according to the story, “Investments: Orlando is the cat’s whiskers of stock picking.”

The cat, an orange tabby named Orlando, managed to win in the end. He wrapped up 2012 with a grand total of 5,542 pounds to the professionals’ 5,176 pounds. The students finished less successfully with 4,840 pounds, according to the story.

“The cat winning shouldn’t surprise anyone. That’s a randomly expected outcome. That is what the efficient market is all about. The market is not always efficient; there are mispriced securities, but they tend to appear and disappear quickly. By the time you figure out that someone out there has that strategy, it’s too late. It’s called the tyranny of efficient markets,” says Larry Swedroe, principal at Buckingham Asset Management and author of the book, “Think, Act and Invest Like Warren Buffett.”

That seems to prove that just about anyone could beat the market at least once or twice. Maintaining that edge is the trick, and it’s one that few active managers of mutual funds achieve. Though investors have been wary of index funds in the past, a recent Wall Street Journal story reports that more and more dollars are going toward passive strategies rather than active.

From the Jounal’s story, “Investors sour on pro stock pickers”:

Through November, investors pulled $119.3 billion from so-called actively managed U.S. stock funds in 2012, the biggest yearly outflow since 2008, according to the latest data from research firm Morningstar Inc.

At the same time, they poured $30.4 billion into U.S. stock exchange-traded funds. When combined with bond ETFs, total inflows to such funds were $154 billion, the largest since 2008.

There’s no word yet on how Orlando the cat will continue his stock-picking career.

The importance of asset allocation

Instead of picking a handful of stocks, most investors should know by now that diversification spreads around the risk of picking the wrong stock and increases the likelihood of picking the right — or best performing for now — stock.

The experiment with Orlando the cat, or Burton Malkiel’s blindfolded monkey in his book, “A Random Walk Down Wall Street,” illustrates “the vagaries of statistical probabilities in individual selections,” says Robert Fragasso, CFP professional, chairman and chief executive officer at Fragasso Financial Advisors in Pittsburgh, Pa.

“If an individual says, ‘I’m going to analyze all of the earnings data, the company data, all of the management profiles and pick the best company,’ they still have a 50-50 chance of being right,” he says.

Instead, Fragasso recommends picking an asset allocation model based on your goals and risk tolerance. From there, investors can build their portfolio with index funds or ETFs representative of each sector of the asset allocation plan.

“Then I will have populated my portfolio in a very basic sense,” he says.

With that foundation, investors can go on to use actively managed funds to fill in holes.

“This is what we do here: We bracket (the index funds) in each of the sectors with two active managers. We use institutional, no-load fund managers and we’ll put in two active managers who have a certain bent in the way they approach things that give them a business-like advantage,” says Fragasso.

There are no guarantees, but it’s a good bet that it will beat random chance.

What do you think about efficient markets?

Follow me on Twitter: @SheynaSteiner.