Active stock picking has been the bread and butter of Warren Buffett’s career. Although a staunch advocate of passive investing for the majority of people, the famous value investor has made his billions by actively selecting stocks that the rest of the market undervalues. The legendary value investor has, however, suggested that even a monkey could see enormous gains in the stock market over time using one simple strategy.
In Buffett’s famous thought experiment, a monkey is given 50 darts and a list of the stocks making up the S&P 500 index. The monkey throws the darts at the list and then purchases the stocks it hits, resulting in a random portfolio.
From there, the monkey does nothing except hold the 50 stocks it initially selected, allowing the portfolio to run without further interference. This incredibly simple approach, Buffett claims, would make even a monkey with no stock market acumen rich, given the passage of enough time.
While this may seem like an extreme suggestion, there’s a great deal of truth behind the idea that 50 randomly selected stocks from the S&P 500 would result in large gains over time. Let’s explore the inner workings of this experiment and see why Buffett’s strategy literally could make a monkey rich.
Why Buffett’s Monkey Strategy Works
Needless to say, Warren Buffett isn’t proposing his theory on dart-throwing monkeys at random. Few people understand the ins and outs of the stock market like the so-called Oracle of Omaha.
Rather than just a comment on the seeming randomness of stock price movements, Buffett’s hypothesis rests on a fundamental observation about long-term stock ownership.
In Buffett’s view, owning stocks is a positive-sum proposition. This means that over time, the overall outcome of owning stocks will, generally speaking, be positive.
While not every individual stock necessarily makes money over the long run, a diversified portfolio of companies will tend to increase in value over time. Since the companies in the S&P 500 are already large, established firms, selecting a cross-section of stocks from this index ensures high quality.
The randomness of the 50 darts would also likely provide diversification. Unlike some indices, the S&P 500 isn’t sector-specific. This means that investors choosing stocks at random from it will get a good mix of companies operating in different industries. Through this mechanism, investors gain a degree of protection from market shocks that badly disrupt one industry but don’t necessarily have an equal impact on others.
How Does the Theory Hold up in Practice?
The real test of this theory is how well any bundle of 50 random stocks from the S&P 500 fares over time. Over the long haul, very few S&P 500 companies have negative returns. The index itself is known to be one of the most stable growth bets in the world. As a result, any random selection of 50 stocks from this index would be very likely to return substantial gains for investors.
With that said, it’s also important to take into account the probabilities of underperforming or overperforming the S&P 500 index as a whole. The more stocks are in a randomly selected portfolio, the higher the probability will be of picking the handful of outliers that drive the index with unusually high performance.
Analyses show that the probability of outperforming the market consistently rises as the number of S&P 500 stocks in a given portfolio increases.
With 50 stocks, investors certainly could outperform the market, but there’s also a roughly equal probability of underperformance. Unsurprisingly, the probabilities reach an inversion point at 250 stocks. At this point, an investor has better-than-average chances of selecting the highest performing stocks in the index.
The moral of the story here is that any 50 stocks in the S&P 500 will almost certainly generate substantial positive returns over a long enough time horizon. However, owning shares in more companies listed on the index decreases the probability of underperforming the market.
Here, it should be noted that Buffett’s strategy doesn’t claim that the monkey would beat or equal average market returns. Instead, his observation is that the monkey would see large returns on its investments over time, even if the randomly selected portfolio did underperform the index as a whole.
The Monkey Strategy vs. Buying the Whole S&P 500
While there’s substantial evidence to suggest that Buffett’s hypothetical dart-throwing monkey would do well in the stock market, there’s also an easier approach to reliably profiting from the S&P 500.
Buying an index fund that purchases the entire index is a guaranteed way to match the overall return of the S&P 500, eliminating the probabilities of underperforming or overperforming due to picking individual stocks.
While certainly less exciting than the combination of monkeys and darts, this approach is a proven method for building wealth in the long run. The annual average return of the S&P 500 is about 10.5 percent, more than sufficient for building up substantial wealth over time. If you had invested just $1,000 in the S&P 500 in 1980, for example, you would have had nearly $120,000 at the end of 2021.
It should also be noted that this exact strategy will eventually be applied to the vast majority of the wealth Warren Buffett has built up. Upon his death, Buffett has left instructions for 90 percent of his estate to be put into an S&P 500 index fund for the benefit of his wife.
So, while the monkey strategy certainly does work, buying the entire index is likely the best bet for most investors. This strategy both simplifies your investing enormously and has a proven track record of generating excellent returns over time.
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