Does Randomization Add Value to a Portfolio?

Does employing reason hurt portfolio performance? That depends on what you mean by reason. Careful investors who understand businesses and invest when the market offers them prices lower than what they expect the business to be worth are one class and reasoning helps them. Passive investors have been able to do very well owning index funds and they can do so without reasoning at all. The problem is that the index funds employ a kind of reasoning and that seems to hurt them.

Reasoning helps some managers and hurts others. How odd. 

A study prepared by CASS Business School, a respected school in the UK, deals with random portfolios selected by methods that have no financial reasoning. By comparison, the S&P500 index holds securities weighted by market capitalization while CASS uses random selection and weighting, an equal weighting of the S&P500 stocks, or a formula based on the Scrabble value of the ticker symbols. The capitalization weighted S&P500 index loses to all of them.

When you think about it a little, that makes some sense. Weighting by capital has implicit factors that are not necessarily rational. Fashion and popularity being two of them. Does APPL have a high stock price and corresponding high capitalization because people feel good about Apple or because its business prospects are better than any other stock in the 500? Fashion has little to do with real value.

CASS did it differently. Apple’s (APPL) Scrabble score is just 6 while Exxon Mobil (XOM) has a score of 12. The scrabble index would weight Exxon 2 to 1 over Apple, while traditional capital weighting would value Apple at more than 2 to 1 versus Exxon.  Clearly the indexes would not be the same.

Finance is not the only place to look for randomization to improve performance. Shahar Avin is a postdoctoral research associate at the Centre for the Study of Existential Risk (CSER) at the University of Cambridge. He recently published this article, Science funding is a gamble so let’s give out money by lottery

The point being that rational selection methods rely on factors that may or not be good predictors. Peer review, published papers, experience, position in the field and more, are historic and could have nothing to do with the ability to achieve the results proposed.

Whether in finance or science, decisions by formula or by reason always narrow the field of choice. Widening the field, as randomization does, improves the likelihood of finding a winner, but at the cost of finding some losers too. Under randomization, that is not a problem because losers can be dispensed with quickly and inexpensively. The process was random, the project has no champion who will lose face because it failed.

Winners run longer. A few winners with big returns can tolerate many small losses and still be profitable. The fundamental of venture capital investing.

Traditional beta seems to be an imperfect measure. Now there is Smart Beta as seen in the CASS study. Some fund families are using “Clever Trackers” that try to weight based on other measurable factors. Growth rate for example. Or dividends. So far there is not much evidence that they work better, but it looks promising.

We have a ways to go before we fully understand passive investing and its underlying and invisible assumptions. Smart passive investors may want to explore some of their choices. Maybe monkeys can beat the market. Possibly not adult monkeys, they think too much. 

Once again it is about meaning and context.

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario.  In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you.  don@moneyfyi.com  866-285-7772

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