The 50-Percent Solution

Investing can seem so complicated. Building a portfolio can involve dozens of decisions, each of which seems terribly important. Here are a few that readers have mulled over recently, according to emails I’ve received:

All of these are thoughtful questions, but each involves a choice between two good alternatives: one is likely to turn out better over the long run, but there’s no way of knowing which one. And yet I regularly hear from readers who are sitting in cash—or worse, sitting in overpriced mutual funds—because they can’t decide which alternative to take.

There are lot of big questions in investing. Whether you use a stock-picking strategy or a passive Couch Potato portfolio matters a lot. Hiring an advisor or investing on your own will also make a dramatic difference. Dumping your GICs for high-yield bonds without understanding the risk? Definitely huge. Decisions like those above—where both alternatives are reasonable, and the superiority of one cannot be predicted—are much smaller. It’s worth spending time weighing the pros and cons. But they’re not worth agonizing over if they leave you paralyzed.

If you’re on the horns of an investing dilemma, here’s a suggestion: do both. Just split the decision 50-50. If your portfolio has 20% Canadian equity, put 10% in a broad-market fund such as XIC and the other 10% in either a fundamentally weighted (CRQ) or dividend-focused ETF (CDZ or XDV). Put 50% of your fixed income in XBB, which covers all the bases, and the other half in a short-term bond ETF. Hedge all the currency in your RRSP and leave it unhedged in your spouse’s. (A couple of commenters on my recent post on currency hedging suggested exactly this. It’s what I do with family’s investments, too.)

The real danger for investors here is not making a dumb call, but regretting a reasonable call that just turned out badly. If you hem and haw before eventually deciding to use cap-weighted ETFs, how will you react if fundamental indexes outperform over the next two years? If you decide to go with short-term bonds only, will you be frustrated if long bonds end up doing better? If it turns out that you were “wrong,” will you chase the returns of the fund that turned out to be right? This kind of second-guessing—and the ill-timed trading it inspires—will be far more detrimental to your returns than a few basis points in a fund’s MER or yield.

Even the great Harry Markowitz wasn’t immune to the paralysis of indecision. Markowitz won the 1990 Nobel Prize in Economics for creating Modern Portfolio Theory, the idea that having uncorrelated asset classes in a portfolio can both increase returns and reduce risk. Yet even he could not bring himself to follow his own advice: “I should have computed the historical co-variances of the asset classes and drawn an efficient frontier,” he wrote, but instead “I visualized my grief if the stock market went way up and I wasn’t in it — or if it went way down and I was completely in it. So I split my contributions 50–50 between stocks and bonds.”

Trying to determine the optimal way to build a portfolio is a worthwhile goal. But never forget that human behaviour is the biggest enemy of investor returns. When choosing between two reasonable options, the best choice is the one you can live with.

12 Responses to The 50-Percent Solution

  1. Jim Yih November 1, 2010 at 10:48 am #

    Great stuff Cdn Couch Potato! I agree with your thoughts especially your last one about the one you can live with. The only comment I will add is the problem of having too many holdings and potential over-diversification and dilution. In my professional experience, I see this problem far too often and it comes not only from the 50% solution but the 25% solution where it gets split into 4 different choices. there’s no shortage of GOOD ideas but important to asses the BEST ones!
    Jim

  2. Paul November 1, 2010 at 5:05 pm #

    I like the idea, but given that I’m now looking at a 7 or 8 ETF portfolio, splitting it into double that puts me around 15 ETFs, which starts getting awfully complicated for a couch potato portfolio, unless you have a whole lot more money than I do to invest !

    Idea for a next blog entry: for someone just starting to build up a portfolio, is it better to go into mutual funds at first, and then migrate the whole portfolio when it reaches a certain number, or to buy decent positions on various ETFs, though this means for a short while being decidedly unbalanced .

  3. Canadian Couch Potato November 1, 2010 at 6:22 pm #

    @Paul: I should stress that I’m only suggesting the 50-50 split if you’re paralyzed by indecision. If you’re comfortable with your choices, you should of course not waver from that.

    Re: your other question, someone with a small amount to invest should certainly start with index mutual funds, not buy one ETF at a time. These links might be helpful:

    http://canadiancouchpotato.com/2010/06/25/should-you-use-index-funds-or-etfs/
    http://www.moneysense.ca/2010/05/27/become-a-couch-potato-investor-with-less-than-5000/

  4. Financial Cents November 1, 2010 at 8:31 pm #

    “But never forget that human behaviour is the biggest enemy of investor returns. When choosing between two reasonable options, the best choice is the one you can live with.”

    Well said Dan, almost like making a consensus decision with yourself.

  5. NorthernRaven November 1, 2010 at 11:52 pm #

    @Paul – not only do you not need to split everything, you wouldn’t have to keep the sub-portions in balance separately, just their total. For instance, you might split your 20% devoted to US equities into 10% hedged and 10% unhedged, but rebalance into one or the other in alternate years. Or, for someone like me getting ready to convert an existing portfolio into index funds, you could buy the 20% unhedged position now, getting a good rate on a big lump foreign exchange, and rebalance with the hedged version. The two will still combine to 20%, and the unhedged ratio would slowly decline, which might be a good thing if you are closer to retirement.

  6. Paul November 2, 2010 at 12:34 am #

    @CPP: Well, I’ll be going contrarian on you here, and say I think it’s best to build my portfolio one ETF at a time, trying to get a mix of VEA, VTI, VSS and VB to get asset ratios that add up with my XIU that I over-invested in before I realised the importance of not having too much of a home bias, all to reach a decent overall asset allocation.

    I think I’m different from the people you were aiming with those blog posts you referred me to in that I have a significant cash flow going straight into savings (and hence, ETF’s), whereas before I didn’t, so I don’t want to take an “interim” fund position, knowing I’ll have to think things through again when I’d go into ETF’s (and that day would’ve come soon enough). Maybe my strategy works for me because I’m catching up on some old mistakes, not truly starting from scratch. Or maybe I’m just being foolish.

    I don’t like the idea of going into high-MER funds when I could be in real equities, though I know I’m losing balance (and I’m kinda trying to time the market, since I’m putting off my bond purchases), so I guess I’m a couch-potato to be…

    Great Blog !
    —-

    @NorthernRaven: wouldn’t that mean losing your asset allocation in terms of hedged vs non-hedged along the way ? I thought the key was the stick to your guns, you’d get overweight in whichever strategy had worked out well recently…. shouldn’t you balance hedged vs non-hedged just as you’d balance emerging markets to MSCI to North America ?

  7. NorthernRaven November 2, 2010 at 1:17 am #

    @Paul – most of Dan’s examples are within an asset class, US equities for instance. So the hedged vs unhedged example is just two reasonable alternatives for your US equity portion. If both are similarly suitable potential strategies for you, various blends should also be suitable, ignoring complexity and trading cost issues. In the US hedging case they are both chasing the same US stock market returns. If you had strong views that 10%/10% was better than 0%/20% or 20%/0%, you were probably never too undecided in the first place!

    As another example, from researching around in places like this there seems to be a school of thought that the extra volatility of long term bonds (like the XBB ETF) may not be worth the potentially bigger returns, and I might decide to prefer the shorter term XSB fund for a hypothetical 25% bond allocation. But if I already own a 10% position of XBB, I’ll just top it up with 15% XSB, and make new purchases into that as well. I’ve got 25% bonds no matter what, and since XSB and XBB are both reasonable alternatives for a couch potato, having a combination is not a big deal, especially as one piece just sits there and doesn’t generate extra trading costs when I rebalance.

    Perhaps we can start referring to this as the Bortolotti Uncertainty Principle… 🙂

  8. Eric November 2, 2010 at 10:50 am #

    Great post !

    To hedge or not to hedge … Unless you have a crystal ball, you cannot predict where the $cad will be in 10 years… But at currency parity and knowing we’re not at PPP (purchasing power parity), than buying US ETF’s is indeed a good deal. I can buy top-notch US companies for less than 5 years ago.

    11/04/2005: 1.18 usd-cad & VTI was $60.00
    11/02/2010: 1.02 usd-cad & VTI: $61.00

  9. Patrick November 2, 2010 at 6:52 pm #

    @Dan: Ok, here’s your next challenge: assemble a low-cost portfolio that achieves a 50-50 split along all four of your bullet points!

  10. Steve November 2, 2010 at 7:51 pm #

    Interesting post Dan – it reminds me of my critical thinking prof in Grad school who told us about a study where undergrads would choose to go on a trip if they did really well on their exams. Undergrads would also choose to go on a trip if they did really poorly on their exams. The first group obviously as a reward for their hard work, and the latter group to try to forget about those darn exams. The interesting part was that a third group of undergrads, who didn’t know what results they were going to get on their exams, did not choose to go on the trip. So, let’s get this straight: if I do well I choose to go, if I do poorly I choose to go, but if I don’t know how I did, I won’t go.

    Apparently, a lack of a clear outcome (which etfs will do better, which asset allocation should I use, which bond fund is more appropriate) paralyzes many, and it’s showing up in the examples you provided at the beginning of your post…

    Good stuff.

  11. Canadian Couch Potato November 2, 2010 at 8:04 pm #

    @Steve: The study you mention is great! Dan Ariely is a social scientist and author who has written a lot about the irrationality we are all subject to. So many of our decisions have to do with how the question is framed.

  12. Canadian Couch Potato November 3, 2010 at 12:47 pm #

    @Patrick: Boy, if an investor is so indecisive that he can’t make up his mind on any of these, he’s in big trouble!

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