Kate Stalter

The debate about market efficiencies isn’t likely to go away, ever.

Proponents of active management look to the shorter-term gains to be had by moving into and out of trades. With the Investor’s Business Daily -style trading that I did for years, you buy into strength and sell into weakness. In certain market conditions, and for those who favor certain asset classes, this type of trading can be effective.

Other trading styles would have you doing just the opposite, buying on the dips and selling into strength. Again, there’s evidence to show that this can work, under the right conditions.

Meanwhile, proponents of the Efficient Market Hypothesis, which my current firm uses, believe that it’s wise to remain fully invested and diversified throughout various market conditions. Decades of empirical research at places such as Dalbar, Dimensional Fund Advisors and academics at the University of Chicago back up the claim that over time, a diversified portfolio, held for the long term, beats the willy-nilly trading and investment styles that most Americans simply fall into.

One of my gripes with the trading system world has always been that it’s difficult for the do-it-yourself-er to adhere to rules, as laid out by various systems. There are actually numerous problems. First, many of the so-called rules are subject to change or whim. Second, the rules are often difficult to understand and follow to the letter. Third — and this is crucial — systems don’t work in every market condition.

Finally, people like to hot rod trading systems. If one indicator is good, then three are better, right?

Yeah, not really.

The biggest problem with active trading is that emotions get in the way of good performance. Most people buy high and sell low. They know they are supposed to act like robots and not panic, but really, how often is that possible? People chase hot investments and jump in at the last minute. It’s the old saying: Once the cab driver starts giving you investment tips, the bull run is coming to an end.

And educated professionals aren’t any less guilty. In fact, sometimes the smartest people are the worst offenders, when it comes to trying to outsmart markets.

But what about problems with an efficient-market style of investing?

There are problems, make no mistake. There’s the potential to get lazy and neglect to rebalance. There’s also the problem of over-diversifying, in other words investing in too many asset classes, just to have your bases covered.

Noted efficient-market expert William Bernstein advises allocating into just four funds: the Vanguard Total Bond Market Index (VBMFX), the Vanguard 500 Index (VFINX), the Vanguard European Stock Index (VEURX) and the Vanguard Small-Cap Index (NAESX).

Laziness and improper diversification are probably the two biggest risks to an efficient portfolio. Investor impatience can also be a risk, if a person can’t sit through downturns or accept that he or she might make less than the S&P 500 in a given year. Just wait: In another year, you will make more.