The Better Lesson From a Stock-Picking Game

Editors’ Note: MarketMinder doesn’t make individual security recommendations. The below merely represent a broader theme we wish to highlight.

Stock-picking games aren’t just for school children learning personal finance: The Wall Street Journal has also gotten in on the fun. One year ago, a group of its columnists picked a portfolio of 12 stocks by literally throwing darts at New York Stock Exchange listings pinned to the office wall, and they competed against a portfolio of fund managers’ “best ideas” as presented at an investment conference.^[i]

Now the results are in, and the dart-throwing writers won. Predictably, the fun article recapping the contest delights in randomness beating professionals and concludes buying equal-weighted index funds is the way to go since they give greater exposure to small outliers than a cap-weighted fund would. But after comparing their detailed results to the broadest universe of trailing one-year stock returns that we were able to dig up, we have a different take.^[ii]

To do this, we pulled total returns from May 10, 2023 through May 10, 2024 for every constituent in the MSCI All-Country World Investible Market Index (AC World IMI) that was listed the whole time. There were 8,926. The median return? 7.9%, with the spectrum ranging from -94.8% to 1,043.2%.^[iii] The range here is quite similar to the columnists’ picks, -97.0% (and delisted) to 1,130.4%.^[iv] But the columnists’ median return was higher, at 24.7%, and their darts landed on high-flyers at higher frequencies than the percentage of index constituents in various return brackets. Random luck, of course, nothing repeatable. Exhibit 1 shows the breakdown, but there is a caveat we will get to momentarily.

Exhibit 1: A Scorecard With a Caveat

Source: FactSet and The Wall Street Journal, as of 5/13/2024. Percentage of companies meeting the selected criteria for one-year trailing total returns in USD.

That caveat: The Journal crew didn’t have long positions in two of their stellar picks. Their game mandated two short positions, and these, too, were picked with darts. Meaning, they didn’t throw 12 darts and decide which 10 would go long and which 2 would be short. They had 10 long darts and 2 short ones, and they landed where they did. One short dart landed on Western Alliance Bancorp. Given their contest started right as regional banks started bouncing from their spring 2023 troubles, the stock had a heck of a run, soaring 140% over the next year.^[v] But having a short position meant it was a big loss-maker. So was their short position in PVH Corp, a clothing company owning several popular American labels that rose 40%.^[vi]

In our view, this is the real lesson. People often ask us whether it is wise to have some hedges in place in a stock portfolio just in case of volatility. We don’t think it is, for the simple reason that if you are in a bull market, the majority of stocks will be up, making hedges likely to work against you. It isn’t just that you miss the positive returns on these stocks. With short positions, you can lose more than your initial investment. Sometimes a lot more, depending on what price you have to buy at to cover those short positions once it is time to close out the position.

People tend to see short positions as easy portfolio insurance—something that rises when stocks fall, offsetting some of the downside. That is true enough when your expectations are correct and the positions fall. You borrowed the stock from a broker-dealer and sold it at a high price, bought it back at the low price, and returned it. So your profit was more or less equivalent to the stock’s decline. But when the stock rises, your downside is the stock’s entire gain.

Even worse, the risks here are asymmetrical. Downside is limited since a stock can’t go below zero. But upside is infinite, at least in theory. This is why the Journal columnists noted their short positions “cost us dearly.”^[vii] It wasn’t just missed returns; it was having to pay a 140% premium to cover one short position and 40% for another. Ouch and ouch.

Now, we aren’t totally against short positions. They can be useful during bear markets—actual broad market downturns that are deep and long and have identifiable fundamental causes. If you spot one early enough that you can reduce stock exposure without running a high risk of missing a rebound in the near term, then short positions might play a role. For instance, you might have some stocks with big unrealized capital gains that would be suboptimal to realize in your current financial situation. Having some put options can be a way to reduce your total equity exposure, in the mathematical sense, while maintaining ownership of these positions.

But the broader lesson here is that going short makes sense, to a very limited degree only, if and only if you think the market has a much higher likelihood of being down a lot over the foreseeable future than up. If your goal is more to reduce your portfolio’s expected short-term volatility because potential wobbles make you nervous, you are better off blending stocks and fixed income as your long-term asset allocation than adding temporary short positions, which can actually cause more harm.

And if you think stocks are likely to stay in a bull market but a correction might strike—a sharp, sentiment-fueled drop of -10% to -20%—we think the best course of action is to remember corrections are normal and a part of stocks’ high long-term returns. Not as things to try to hedge around. After all, the contest year included a correction last summer and autumn. But the short positions were still a bloodbath.

So yah, fun game! But the lesson, to us, is perhaps not the one the players intended to teach.