Experts will tell you that you need to be prepared before you start investing. Have a plan, budget carefully, tediously research companies, listen to analysts et cetera.
However, experiments have been carried out to test if this is really true. Do you really need a carefully crafted portfolio, or can you get by with just picking a bunch of random stocks?
After all, what use is advice if nobody goes out and finds out what happens when you don’t follow it? However, when money is at stake, the thought of leaving your investments to chance might not be a decision many people will choose.
Can you win by chance?
Actually, this idea of not choosing investments intentionally has been tested with surprising results.
In 2019, a group of Wall Street Journal writers tested the theory that it’s possible to beat the S&P 500 by random chance. To do this, they put pages from the daily stock market updates on a wall and threw darts at it to determine which stocks they would buy.
Success for these writers would be beating funds picked by a handful of professional investors. Surprisingly, they did – by a massive 27%.
Earlier studies also experimented with using cats and monkeys to pick stocks – both also resulted in the seemingly random selection of stocks beating expert analysis.
These results may show that there is no harm in letting your house cat hop on the keyboard and select stocks at random. But is that really the case?
What does it actually mean?
Choosing random stocks by throwing darts at a newspaper may mean you end up investing too much of your money in small market capitalisation companies – these companies tend to make up the bulk of the stock market, so you are more likely to end up hitting one of them.
Generally, investing in small cap companies can provide bigger returns in the short run if the economy is in the growth stage. For example, a RM200,000 increase in revenue is massive if you’re only bringing in RM500,000 a year; but is less impressive if you’re already pulling in RM5 million.
In other words, the same amount of growth will have a much bigger impact on smaller companies. This, in turn, greatly increases stock performance. After all, a stock price going from RM1 to RM1.20 is a 20% increase.
We don’t know which stocks the researchers ended up choosing thanks to random selection, but they would have likely been heavily invested in small-cap stocks as there are simply more of these compared to larger capitalisation ones.
Would this work for you?
Technically, yes. At least in the short run, and if you know what you’re doing.
The benefit of small-cap stocks is that they do increase in value very quickly in proportion to how much you invested. However, the downside is that they can also lose value at the same rate. This puts them into a position of being extremely risky investments.
Additionally, these small-cap companies may lack access to capital which may affect the amount of growth they can manage. It is often difficult to tell where the company really is from just looking at the stock price – you never know if they’ve hit their limits and will have trouble growing from there especially if you happen to be choosing your investments at random.
Finally, a random selection of stocks may leave you with an unbalanced portfolio. In this case, you may be more exposed to economic shocks in the long term. The random test we discussed earlier did not take into account longer-term exposure to stock market cycles so this risk was never addressed by the researchers.
The researchers only tracked their randomly chosen stocks’ performance for one year – and was during periods of economic growth. In fact, these studies happened just as the US economy was recovering from a recession in 2011.
We cannot say how they would fare under different circumstances.
Diversity is important
Diversifying is usually the safest way to go about your investments. Beating the market due to random chance makes for a good story, but actually having a plan is what will carry you all the way to financial freedom.
After all, you need to know what to do when all your investments are on the decline. No, the answer is not to move them all into another set of random stocks.
This is why many people look to unit trust funds as their investment of choice. It not only offers a variety of funds that fit any risk profile, they are also carefully managed to ensure that the funds don’t suddenly collapse in the event of a recession (which can be a risk for many small-cap companies, especially now).
