Does This Thing Work?

July 29, 2010

This week I received an email from a reader of MoneySense magazine, where I write regularly about the Couch Potato strategy. Kate was concerned that index investing wasn’t delivering on its promises. With her her permission, I’d like to share her email and my response to her concerns, which I’m sure others share.

It’s important for new index investors to understand that the strategy guarantees simplicity and low fees, but it’s still at the mercy of Mr. Market. It’s also another reminder that ETFs may not be appropriate for small portfolios.

Dear Dan,

I have a financial advisor who oversees my investments. I was shocked to read in your articles about how much commissions and fees add up over the years. I am not financially savvy and have left it up to my advisor to deal with my investments, and I have been disappointed in how little they have grown.

Then I read an article about the Couch Potato strategy in the February/March 2007 issue of MoneySense and wanted to give it a try.  I took $10,000 and invested it in the High-Growth Couch Potato portfolio. I invested 25% in each of the following:

iShares &P/TSX Capped Composite (XIC)
iShares S&P 500 CAD-hedged (XSP)
iShares MSCI EAFE CAD-hedged (XIN)
iShares DEX Universe Bond (XBB)

As indicated in the article, I have rebalanced once a year, but I am finding that I have not made any gains. My $10,000 is now at $9,058.20. I had read that gains were steady with the Couch Potato strategy but do not see that with my portfolio.

So, my question to you is, am I in the right investments? Do I just need to wait it out longer and keep rebalancing each year? Do I need more than $10,000 in the portfolio to make it worthwhile?

It’s hard to blame Kate for her frustration. The article she refers to included stats that showed the Classic Couch Potato portfolio would have had an annualized returns of 11.8% from 1976 through 2006. Here’s how I answered:

Dear Kate,

I’m sorry to hear that you have had a negative experience with the Couch Potato strategy.

It’s important to understand how the strategy works and what it is designed to do. You write that “I had read that gains were steady with the Couch Potato strategy,” but this is not something we would have ever written in MoneySense, because it’s not true. The only investments that provide steady gains are savings accounts and GICs.

The Couch Potato strategy is designed to deliver the same returns as the overall stock and bond markets, minus very small costs. Index funds and ETFs offer no protection from a falling market. The only thing they promise is that your gains or losses will not be significantly different from the indexes, and that you won’t be losing 2% or more each year in fees. The funds your advisor uses will sometimes lose less or gain more than the indexes. But over the long term this is unlikely to continue, because the drag caused by fees is relentless.

You mentioned that you got started with the Couch Potato strategy in mid-2007. Through no fault of your own, this turned out to be terrible timing. Stocks markets around the world saw huge gains between 2003 and 2006, and mid-2007 was the peak of that long bull market. So you had the bad luck of buying when prices were highest. Things immediately got worse in the second half of 2007, and then 2008-09 saw the worst crash since the Great Depression.

Just about everyone who had money in the markets—and your portfolio was 75% stocks—lost money during this period. The Canadian, US and international markets are still lower than they were in 2007, so the ETFs that track them are down, too.

You also asked whether you need more than $10,000 in the portfolio to make it worthwhile. In some ways, the answer is yes. Using ETFs and rebalancing once a year is inefficient with small accounts. Many discount brokerages charge $29 per trade, so the cost of rebalancing is about $116, or 1.16% annually on a $10,000 portfolio. Of the $950 you have lost in your portfolio, more than a third would have been from brokerage commissions if you have done three rebalances (12 trades at $29 = $348).

If you decide to stick with ETFs, you might consider rebalancing only every two years (or even less) to reduce the costs. But you may even want to think about index mutual funds instead. These two articles offer detailed suggestions for using the Couch Potato strategy in a small portfolio:

Become a Couch Potato Investor With Less Than $5,000

Should You Use Index Funds or ETFs?

{ 16 comments… read them below or add one }

Canadian Capitalist July 29, 2010 at 11:31 am

A portfolio that is mostly invested in stocks, cannot deliver “steady gains”. Let’s take a look at what returns the high-growth portfolio would have delivered from different start years to 2009 (these are annualized returns obtained from the Stingy Investor Asset mixer calculator). One more caveat, XSP and XIN do not perfectly track US and International markets because of currency hedging.

2000 – 2.07%
2001 – 2.26%
2002 – 3.46%
2003 – 5.66%
2004 – 4.43%
2005 – 3.52%
2006 – 1.83%
2007 – (2.53%)

As you can see, returns are anything but steady. The promise of the couch potato portfolio is that by cutting expenses and keeping emotions in check, you are mathematically certain to outperform the average investor. It makes no claims on steady returns or even positive returns over any time period because when it comes to stocks there is no guarantee. That’s the risk you are taking. And stocks are highly likely to reward you for that risk by providing higher returns than risk-free cash. But, that’s an expectation, not a guarantee.

http://www.ndir.com/cgi-bin/downside_adv.cgi

Canadian Couch Potato July 29, 2010 at 12:18 pm

@CC: Thanks for cranking out these numbers. Not only do they show that Kate had the misfortune of getting in at the worst time (well, mid-2008 probably would have been worse), but the returns highlight that this really has been a terrible decade for investors. If you bought in at the height of the dot-com bubble, you earned 2% annually for 10 years, and that’s only if you had the stones to hold on.

Another point here is that we don’t know what would have happened to Kate’s $10,000 if she left it with her advisor. (The $10K was just a small sliver of her retirement savings, which she wanted to use to experiment with the Couch Potato.) She may well have lost more.

Chris Heaman July 29, 2010 at 12:28 pm

Markets move in 2 directions, always have, always will….theres more to it than what you have said. Everyone wants it to be simple, wants it to be easy and wants it to be cheap. My father used to say, buy the right tool for the job, and buy quality, do not buy it cheap, you will pay for it eventually, and possibly more. ETFs work …all investments do what they are supposed to, they just don’t do it when we want them to. Being biased LONG can lose you money over short periods of time, and short isn’t measured in months or days or weeks, it’s measured in years.

Financial Cents July 29, 2010 at 7:22 pm

I feel sorry for Kate b/c she did the right thing but got burned. The market was great until 2007, after that, well, we all know.

I think if Kate holds on (I hope she does) to ETFs over the next few years, she’ll be glad she did. If anything, she should buy more XIC and not worry about rebalancing at least until early 2011. Rebalancing is not really needed if she’s close to an even four-way split.

Thanks to Kate and Dan for sharing this story. Got any more mail you can share Dan?

Marz July 30, 2010 at 9:10 am

“The promise of the couch potato portfolio is that by cutting expenses and keeping emotions in check, you are mathematically certain to outperform the average investor.”

That’s great, but why do I care about the average investor? I mean, if they lost 40% and I only lost 25%, I should be happy? It sounds like it’s easier to forget about outperforming anyone and just invest completely in GICs. That way you don’t lose anything.

Michael Davie July 30, 2010 at 9:19 am

“It sounds like it’s easier to forget about outperforming anyone and just invest completely in GICs. That way you don’t lose anything.”

This is only true if you don’t consider the opportunity cost, i.e. you give up any chance of making more than you can with a GIC, and that chance has value. Investors are compensated for increased risk with the potential for increased returns, so if you take no risk you can expect the lowest return.

Canadian Couch Potato July 30, 2010 at 9:54 am

@Marz: You’re right, of course, that your investing goal shouldn’t be to outperform the guy next door, or your brother-in-law, or the average investor. And, no, you won’t be happy if you lose 25%, but as a Couch Potato investor you do have to accept what the market delivers. Over the long run, you should expect to be rewarded with higher returns than most investors who either hid in GICs or tried to outsmart the market.

Kate July 31, 2010 at 2:39 am

Your comments, suggestions and encouragements posted, have really helped me to further understand/verify the couch potato strategy and reassure me that I need to hold the course for now, and wait things out. Thanks!

Another question comes to mind after I read the above comments posted, as well as Dan’s latest article “How to Save a Million Bucks.” I just put a small amount of my investment $$ into the couch potato strategy, to give it a try and get comfortable with the trading online. My question is, when one becomes more confident with the couch potato strategy, would it be wise to put all investments in this strategy and therefore eliminate the advisor and the excess fees? (Of course knowing that one needs to put $$ in the less risky couch potato strategy as retirement is near).
Is there any time one would have/keep a financial advisor?

Farhan Thawar July 31, 2010 at 12:24 pm

Awesome post, worthy of forwarding. One thing to think about is to also perhaps talk about another strategy that is worthwhile called a Barbell. It’s not a couch potato strategy, but is likely the only other strategy I consider worthwhile.

Basically you invest 80-90% of your investments in safe investments (Bonds, GIC, etc.) and the remainder 10-20% in ultra risky stocks. Likely better than just stock picking.

Canadian Couch Potato July 31, 2010 at 4:40 pm

@Farhan: Thanks for your comment. I see you’ve been reading Nassim Taleb’s The Black Swan! It seems to me that the most likely outcome of such a strategy would be that you would earn a bit less than the average return of the safe investments, because most of the time the ultra-risky stocks would blow up. If you had an infinite number of lifetimes, then on average, this might work out fine. But I’m only investing for one lifetime. I’d rather have a well diversified portfolio and buy the odd lottery ticket!

Canadian Couch Potato July 31, 2010 at 4:44 pm

@Kate: There are definitely good reasons to use an advisor: many provide valuable advice about risk management, retirement planning, tax deferrals, etc. There are also a lot of bad reasons, such as “My advisor says he can pick investments that will beat the market,” and “My advisor knows how to time the market to protect me from downturns.” You’ve made me think it’s time for a post or two about this subject.

Canadian Couch Potato August 1, 2010 at 9:31 am

Just noticed a recent column by Gordon Pape that touches on this exact issue: he discusses a portfolio of the same for ETFs and looks at its performance since early 2008: “The whole idea of using a basic ETF portfolio is that over time, you will make a decent return on your money. Every study of this concept has shown this to be the case. The problem is that investors tend to be impatient. When nothing happens or when the market falls, they abandon the idea and move on to something else, locking in a loss in the process… There is no way of knowing when this passive portfolio will get back into profit territory. But before you dismiss the theory entirely, take a look at your own portfolio. Has it performed better or worse than our ETF model since January 2008? In many cases, the answer will be worse – perhaps much worse.”

Farhan Thawar August 2, 2010 at 4:10 pm

The only thing that scares me about the couch potato, is if we get into a Japan like slump with no returns for years and years.

Rick August 2, 2010 at 6:14 pm

Could you explain “what it means” to hedge an ETF to mitigate the effects of the US$/CDN$ exchange (ie does that mean that if the SP500 goes up 10% in US$ then our Cdn$ holdings in the ETF goes up 10% too?) and secondly (how is it done – in layperson’s terms please!) Many thanks

Canadian Couch Potato August 2, 2010 at 6:47 pm

@Rick: Yes, your explanation of hedging is pretty much dead on. In an unhedged fund, if US stocks return 10% in USD, but the Canadian dollar gains 3% relative to the US dollar, then Canadian investors in the fund would earn only 7%. Of course, if the US dollar were to rise 3% during that period, the Canadian would earn 13%. In a fully hedged fund, Canadians would earn 10%, the same as they underlying stocks.

The hedging is done with “currency futures.” These are contracts that lock in a fixed exchange rate for a given period. Funds that hedge foreign currency typically readjust the hedging every month, so slow, gradual changes in the exchange rates can be easily adjusted for. However, there’s no free lunch. Currency hedging adds to a fund’s cost, and this is on top of the MER. Note also that the hedging is not always accurate, so sometimes you don’t even get the protection you pay for.

This is the best explanation of hedging I have found:
http://www.mackenziefinancial.com/eprise/main/MF/DocLib/Public/MF3926.pdf

Rick August 2, 2010 at 9:57 pm

Many thanks for your confirmation of understanding and also the the pointers to further information.

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