The Error-Proof Portfolio: Normal People Don't Invest Like This

"Who are these people?"

That's what I found myself wondering during the market's latest bout of schizophrenia. As stock-market sentiment seesawed from black despair to brief bursts of manic euphoria, I scratched my head about who (or what) was driving it.

Not me. Not my colleague John Rekenthaler, who calmly opined that he was recently doing a little tactical buying when things were way down. Not the folks on Morningstar.com's Discuss boards. On days when the market was in freefall, many posters were mildly counseling one another not to panic and pointing to opportunities; others appeared to be paying no attention at all to the market's frenetic actions, instead discussing retirement-portfolio withdrawal rates and finding the best deal on certificates of deposit.

No, typically small investors don't lead these violent market movements (intraday, no less). Instead, such shifts are usually driven by big institutional traders, including hedge funds and so-called high-frequency traders, executing trades on behalf of their clients. Once they get started, it sets off a cascade effect: Program trades kick in, whereby securities are automatically sold once certain thresholds are breached, and holders of losing stocks on margin are forced to sell stuff to meet margin calls. After a while, when the selling has really picked up steam, smaller investors often get in on the action.

If you're watching all of this unfold from a distance, you might take extreme market movements as a call to action. If more than half of the world is buying stocks on Tuesday and selling on Wednesday (or worse yet, buying them at 9 a.m. and selling at 3 p.m.), you might naturally assume that this is a successful way to manage your money. You would be wrong.

That's not to say that no one can make money with a rapid-fire trading strategy that hinges on macroeconomic or technical factors. In fact, the Wall Street Journal recently reported that some hedge funds had been able to score during the recent downturn, notching gains as high as 25% during the past month alone. (Whether hedge funds in aggregate have a good track record of delivering strong returns is an open question that isn't likely to be resolved anytime soon; even more than is the case with the mutual fund industry, hedge fund operators tend to kill their young and weakly performing offerings, making it difficult to draw meaningful conclusions about such funds' long-term performance.) For all I know, there could also be day traders in Poughkeepsie, N.Y., or Tacoma, Wash., who have found similar levels of success by rapidly adding to and trimming to exploit short-term pricing inefficiencies.

However, the track record of professional mutual fund managers employing tactical strategies isn't that hot. And small investors looking to employ such strategies face risks on a couple of fronts. The first is that you're apt to be competing with people who have access to a lot more information, and systems for sorting through it more quickly, than you're privy to as a smaller investor. (One asset-management executive once likened this mismatch to thinking you're playing a casual game of tennis but looking across the court to see Serena Williams.) Nor are small investors able to swing good deals on trade execution like large institutions are; those trading costs could chip away at any profit you're bound to wring out.

But perhaps the most important reason to eschew a hands-on, rapid-fire trading strategy is that there are proven ways to manage a portfolio that are a heck of a lot simpler and lower-stress. By taking a long-term, strategic approach to setting your stock/bond/cash mix and then periodically rebalancing back to your targets and making your portfolio more conservative as you age, you won't have to touch your equity allocation during market swoons unless it's time to prop your equity allocation back up.

You can also take a similarly unfussy approach to security in asset allocation, further enabling yourself to tune out the noise on hypervolatile days. You could index your equity portfolio, delegate all or some of your portfolio to an active fund manager, buy individual stocks yourself, or employ a combination of those strategies. Such an approach isn't likely to provide you with good cocktail party fodder after the kind of week we've just had, but that's the whole point.

David Boddy contributed to this article.

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