After reading a heated discussion in a personal finance forum earlier this week, I thought it would be a great idea to write my thoughts on one of the most intensely debated and discussed issues in finance. This is a question that I ask MBA grads during 1st round interviews. You’d be surprised how often very smart people can sound very stupid when asked if markets are efficient, and what to do about it.

There are two basic schools of thought in regards to investing in the stock market. In one corner we have the active investor. She believes that markets are inherently inefficient. An inefficient market is one where prices do not accurately reflect the value of an asset at that point in time. Therefore, some stocks will be “cheap” and others “expensive”. The goal of the active investor is to purchase the “cheap” stocks and then sell when they match/exceed their true value.

On the flip side we have the passive investor. He believes that the market is efficient and all prices accurately portray the true value of an asset. There are no “cheap” stocks. Everything is priced to perfection for that point in time. Depending on how far the investor is on the passive scale, they either base purchases purely on future expectations, or opt for the ultimate in passive investing: indexing.

Which is the better approach?

Both have pros and cons and I will try to point out just a few as some food for thought. Since this is such as touchy and personal subject, I know many will disagree with me and I encourage you to sign up and debate it out in our new forums.

Firstly: Are markets efficient?

No.

No, they are not. They never were. They never will be. If every human acted like a robot, then maybe they would be. Humans are not robots (yes, even the one’s at MIT) and do not all react to produce the same output when given an identical input. My favorite example is the after hours equity market during earnings season. When a company reports its earnings, investors are given some time to digest the news before trading is allowed to resume. What often happens are huge price fluctuations as the market “feels itself out”. The next morning when regular trading resumes, the stock can end up going in the complete opposite direction from the night before. How is that logical? Every participant got the same information at the same time. If the market was truly efficient, the pricing should be relatively stable after the news was made public.

Active Investing
Pros

• More fun - This might seem like a silly and illogical pro. People invest to make money, not for fun! That’s not really true though. Most active investors love the thrill of researching companies in order to find the gems that they believe will make them money. It can be fun, although potentially misleading.

• Diversification - Through active investing, you can create custom portfolios that provides hedges and diversification that can insulate a portfolio from market instability.

Cons

• It usually doesn’t bring better gains. When looking at the performance of money managers over the long run, the vast majority under perform the index. There are often specific reasons for this, I’ll leave that for another feature.

• Cost. Running an active portfolio often results in more transactions and different positions, creating a larger costs through commissions and fees.

Indexing (The ultimate passive approach)

Pros

• Easy. There’s no research to do. Just pick up an Indexed product and hold it.

• Cheap. Fees on indexed products are significantly lower than active products.

• Performance. The index will outperform most managers, so why even bother with the high fees and lower performance?

Cons

• Diversification Risk. Indexes are not perfect diversification tools. Sometimes the weighting of a sector or even a specific stock can cause a massive skew in the composition of the index. One stock or sectors collapse can cause massive damage to the index and your portfolio.

In the end, it really depends on which strategy suits what kind of investor. If you don’t want any professional help and don’t have the time to research, then indexing might be your best bet. If love the thrill of stock chasing and picking, you’re probably already an active investor.

Best of Luck!