Recently there have been spate of articles on personal finance blogs dealing how to deal with the volatility in the market. Trent at The Simple Dollar had a lively debate on his hands when he suggested that someone should not invest in something (stocks) in it makes them uncomfortable. Nickel makes a solid argument to ignore the market volatility and stay invested.

While I am fairly risk adverse and generally support a passive index fund approach toward investing, I tend to advocate what is commonly thought of as more risk than the average personal finance blogger. There are plenty of blogs in the personal finance space dedicated toward investing such as Moomin Valley. However most blogs that really focus on personal finance, and almost all the really quality personal finance blogs preach a passive index investing style. Do I disagree with this style? Hardly. I think most people should listen to the cantankerous curmudgeon who is John Bogle, and adopt the Bogle approach. That said, I believe many of us can afford more risk, and not only that but proper deviation from the all index fund, dollar cost averaging approach towards investing is inherently not more risky. Do I think most people are qualified or have the time to actively invest? No. I remain wholly unconvinced if I have the aptitude or the time myself.

If you ever hear what John Bogle has to say about investing, his whole mantra is about reducing transaction costs. The man knows what he’s talking about, and that is truly the only advantage index funds have versus individual stocks and actively managed funds. I completely buy into that, and think it’s a great reason to adopt a basic index fund strategy. The problem is often times when people argue for passive index fund investing, the arguments imply that somehow picking individual stocks and or trying to time the market is more risky. A poorly diversified portfolio of individual stocks is more risky - that is true. However even with 30 stock holdings it’s possible to construct a fairly well diversified portfolio that should have volatility similar to an index such as the S&P 500. Hell, the Dow Jones Industrial Average is only 30 stocks, but then again it’s really not much of an index for the modern era.

Assuming that you have a stock portfolio that is diversified enough to give it a similar volatility to say the S&P 500 is there any reason for it under perform the S&P 500? If you believe in an efficient market then there’s no reason for that handpicked portfolio to under perform. It should perform differently either better or worse, but no inherent reason for it to perform worse. If the markets aren’t perfectly efficient then picking individual stocks gives you a reasonable chance to outperform the market if you have both skill and time. The case for market timing is much more tenuous. If we believe that the long term trend of the market is upward, we should always be invested. I believe in that long term trend. However, at the same time I do believe there are times when the market does get out of wack. Was the value of the NASDAQ in 2000 rational? Hardly. The question with market timing is when do you get in and get out? It’s my belief those are generally determined by the larger economic picture. My general strategy for market timing is active re balancing. I don’t have preset times in which I re-balance my portfolio, but rather make an assessment of the current state of the stock market and economy, and re-balance my portfolio. I sell winners and buy into undervalued or defensive sectors. However I think one key is not reacting, but rather anticipating. The volatility of the market should not be driving the decision to sell or buy.

John Bogle is right about transaction costs, but because of the success of the revolution he has led, transaction costs have gotten low enough that for many investors that it does need to be the critical concern. If transaction costs from trading is low enough that it shaves less than .1% (10 basis points) annually from total performance, it might be worth taking a chance that the market is inefficient. Over 30 years that 10 basis points would make difference of about 3% assuming a return of 10%. I’m the type of person who’s willing to trade 4% for a chance at much higher returns. Assuming that I could eke out just an extra 1% in performance annually that would make a nearly 30% difference at the end of 30 years. Before the advent of all the low cost trading options, transactions costs could easily have been 1% or more, making the argument for passive index investing so much stronger. 30 years ago, I would never have advocated active investing because the hurdle of overcoming the transaction cost would’ve been too high. I might think maybe I can eke out 1%, but when transaction cost might have been 3%, I hardly think I would be able to eke out 4%.