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Sunday, Jan. 20, 2013

Beating the cat: Can your pet succeed in the stock market?

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Latest by WiseOldMan 1 year 39 weeks ago

It’s been going on for months at our house – a vague discussion among family members on whether we should acquire a cat.

I have decided. We’re getting a cat, all right – and we’re going to make a killing in the stock market.

Oh yes. The two are connected.

Last January, the London newspaper The Observer started a contest to see if experience made a difference in picking winning stocks. Organizers formed three teams: financial professionals (a wealth manager, a stockbroker and a fund manager); 11 English high-school students; and a 2-year-old yellow tabby cat named Orlando.

Each group received £5,000 to invest in stocks on the London Stock Exchange’s All-Share Index. Every three months they could rearrange their portfolios. The financial pros and the students pored over numbers and trends. The cat batted his favorite toy mouse around a numbered chart.

After Dec. 31, the results: The students lost £160. The financial pros gained £176.

Orlando beat them all, coming out £546 ahead.

The temptation is clear: Ditch your investment manager and buy a cat.

Now before I have to stave off hordes of angry financial advisors who are outraged over this, I have to tell readers something: This is not a jab at the human experts. You don’t really have to get a cat.

You can get a monkey.

Organizers in Russia staged a similar challenge in 2009, pitting all of the nation’s investment funds against a circus chimp named Lusha, who would periodically select cubes that symbolized certain companies. Lusha beat 94 percent of Russia’s human-tended investment funds.

The more I dug, the more examples I found of animals going up against financial experts – and folks, the animals are winning.

So I called Simon Medcalfe, an assistant professor of finance at Georgia Regents University’s James M. Hull College of Business. He has (1) a Ph.D., and (2) an English accent, which makes anything coming out of his mouth sound much more plausible.

I asked him: What does it say about the stock market when an animal’s random picks can outperform the picks of seasoned investors?

“It tells me that the stock market’s pretty efficient,” Dr. Medcalfe said. “You can’t beat the market.”

By “efficient” he’s talking about the efficient-market hypothesis: An investor can’t consistently exceed average market returns because prices reflect all available information about a stock share’s worth.

That makes it very hard to identify undervalued stocks, Dr. Medcalfe explained. If you can spot an undervalued stock to make a killing on, so can anybody else.

“If you can identify an undervalued stock, and I can, then everyone’s going to realize it’s an undervalued stock and we’re all going to buy it, and so eventually the price will rise to reflect its fundamental value,” he said.

But how is it that an animal can post better stock picks?

Forbes magazine contributor Rick Ferri touches on a likely answer: The animals who pick at random tend to pick many more smaller stocks, which can tend to slightly outperform larger stocks over a long haul. To the amusement of animal lovers everywhere, it gives the illusion that cats and monkeys actually know what they’re doing.

Another significant factor, Dr. Medcalfe said, is human overconfidence.

He described an exercise he conducts with his students. Dr. Medcalfe asks them to give their estimates, with 95 percent certainty, on the length of the Nile River – between “x” and “y” number of miles.

The safe pick would be to say from zero to 10,000 miles, right? But students almost invariably – and often incorrectly – choose a much smaller, riskier parameter of, say, a couple hundred miles. “We’re overconfident in our own ability, maybe, to predict stocks,” Dr. Medcalfe said. “People think they know more than they do.”

But animals aren’t encumbered with such human frailties as confidence or doubt when it comes to the stock market. “You go to a humane society and get a cat, it doesn’t have these emotions. It doesn’t have these behavioral responses,” Dr. Medcalfe said.

And not only are we humans overconfident, we’re stubbornly overconfident. An article in The Economist on Jan. 12 addressed just that. A pair of finance professors conducted a study comparing the opinions of respected economists with the opinions of average schlubs on the street. They found, among other things, that while
100 percent of economists said it was hard to predict stock prices, only 55 percent of the public thought so.

“The public actually grew more confident in its ability to pick stocks successfully after learning that economists think it is close to impossible,” The Economist said.

“Either we’ve got absolutely no faith in economists, or we’re just making irrational, not-very-intelligent decisions as a people in terms of trying to beat the market,” Dr. Medcalfe said with a laugh. “It’s unbelievable.”

His advice? Skip the cat, and get an index fund. It’s a low-cost way of getting into a diversified portfolio. You can buy them in relatively small quantities. Commissions are low. You can buy them and not sweat watching the market every day.

“But you talk to some of my other colleagues here in finance, and some of them do follow the market more,” Dr. Medcalfe said. “They do believe that they could beat the cat.”

Perhaps. But primates’ rates of return look pretty good, too.

Maybe I’ll get a monkey.

Hey, it’s an investment.

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