Why Staying the Course Isn’t “Doing Nothing”

On Tuesday I linked to a poll of some 200 institutional investors who were asked about their outlook for global equity markets. The smart money seems to be evenly split between buyers, sellers, holders, and those who “are confused and doing nothing.”

It’s funny that investors who don’t react to market swings are said to be doing nothing. This is one of the enduring myths about index investing: that carefully building a diversified, all-weather portfolio for the long term makes you a naive fool because you’re not constantly “repositioning.”

Staying the course is not “doing nothing.” On the contrary, it’s doing something thoughtfully and productively rather than constantly reacting to the market. The first three quarters of 2011 have been a marvellous example of how diversifying and ignoring forecasts can work so well during times of market stress. To see this idea in action, let’s do a Q3 check-in with the Complete Couch Potato.

No, everything does not go down together

Dumping bonds was supposed to be part of the “reposition your portfolio for today’s market” strategy—actually it’s been a refrain for about three years now. And once again, the bonds that everyone hates because “interest rates are guaranteed to go up” have proven the fortune tellers dead wrong. The iShares DEX Universe Bond Index Fund (XBB), which makes up 30% of the Complete Couch Potato, has returned 7.20% on the year (all figures as of September 30).

Another 10% of the portfolio is in real-return bonds, which historically have some negative correlation with equities, and even a low correlation with nominal bonds. That’s why they make such an effective diversifier. So far this year the iShares DEX Real Return Bond Index Fund (XRB) is up 9.53%.

The portfolio allocates 10% to real estate, which also has a rather low correlation with the overall equity markets. Sure enough, while the S&P/TSX Composite is down over 12% so far this year, the BMO Equal Weight REITs Index ETF (ZRE) is up almost 6%.

Equity markets in Canada, the US and overseas are all deep in the red so far this year. But they’ve fallen to different degrees and at different rates, which means that global diversification has smoothed out the volatility. The headlines have focused on Europe, but emerging markets (“the only place you’re going to see growth”) have been the big losers, down 22% so far. Stocks in the US (you know, the country you were supposed to avoid because of their huge debt problems) have lost less than half as much and are on track to outperform Canada for the first time in years.

To add another layer of diversification, the Complete Couch Potato avoids currency hedging for its foreign holdings. This has provided a huge cushion during the bear market, as the US dollar is up more than 11% against the loonie since May 1, and the euro (surprise!) is 8% higher than it was in early January. As a result, the Vanguard Total Stock Market (VTI) is down almost 10% in US dollars, but has fallen just 5.26% for Canadians. The Vanguard Total International Stock (VXUS) is down 18% in its native currencies, compared with 13.82% in Canadian dollars. (Thanks to Justin Bender of PWL Capital in Toronto for these figures.)

How you did if you “did nothing”

Here’s how all of these elements have come together in the Complete Couch Potato the first nine months of 2011:

Fund Ticker YTD return
iShares S&P/TSX Composite XIC 20% –12.02%
Vanguard Total Stock Market VTI 15% –5.26%
Vanguard Total Int’l Stock Market VXUS 15% –13.82%
BMO Equal Weight REITs ZRE 10% 5.77%
 iShares DEX Real-Return Bond XRB 10% 9.53%
 iShares DEX Universe Bond XBB 30% 7.20%
Total –1.6%

.

As the media scream at you to do something to protect your investments, this simple, balanced, diversified portfolio is down a mere 1.6%. Even amid all the gloom of 2011, do you think you would have been tempted to abandon your plan after such a trivial loss?

My point is not that 2011 has been a particularly good year to hold bonds, or real estate, or to diversify globally, or to have exposure to foreign currencies. I’m saying it’s always a good year to diversify in this way. By getting exposure to all these asset classes, all the time, you’re prepared for just about anything the markets will throw at you. Next year, if stocks rally and rising interest rates finally do take a bite out of bonds, you’re equipped for that, too.

Diversification is not perfect, and it doesn’t guarantee positive returns every year. But it is still the best tool we have.

18 Responses to Why Staying the Course Isn’t “Doing Nothing”

  1. Jon Evan October 7, 2011 at 1:06 pm #

    Some bear equity markets can last a number of years.
    Your Portfolio YTD has lost ~30% in equities and gained ~22% in fixed income.
    Does this mean that soon to rebalance you will have to sell fixed income to buy equities? Or are you going to use new money to do that?
    What if next year mirrors this one? You will again have to sell fixed income to buy equities to maintain the asset allocation diversification that you’ve chosen.
    That takes a certain fortitude to sell what’s doing well to buy what is doing poorly. I guess the ‘do nothing’ is referring to a certain mindset to follow a plan and doing nothing about the prevailing times to change one’s resolve! That’s the hardest for my wife (to be frank) and she is my accountant!

  2. SavingMentor October 7, 2011 at 1:30 pm #

    Great analysis. Staying the course can be tough when the water gets rough but relying on a solid plan is definitely the way to go. Getting too emotional will almost always end up hurting you in the long run. I’ve made some emotional mistakes that cost me for sure!

  3. Canadian Couch Potato October 7, 2011 at 2:56 pm #

    @Jon Evan: I think you know what my answer will be, so I’ll turn it around and ask you what alternative you suggest. How did you invest your money over the last 12 months, and why? And how have you repositioned your portfolio for the next 12 months, and why?

    I also need to correct your math. The equity portion of the portfolio (not including real estate) has lost a combined 10.53% YTD. The real estate/bonds have gained 7.38%.

    @Saving Mentor: I think you’re right that one of the biggest benefits of a passive strategy (assuming you have confidence in it) is that it keeps you on course even when you don’t have a map. Allowing your portfolio be ruled by emotion is a recipe for disaster—although we’ve all done it at times. :)

  4. Canadian Couch Potato October 7, 2011 at 5:35 pm #

    Check out this line from today’s Financial Post: “Remember that diversification will offer you absolutely no protection. When investors sell en masse, they sell everything. You might think that a diversified portfolio will protect you, but in a bear market/recession, it likely won’t.”

    Um, right.

  5. Jon Evan October 7, 2011 at 6:53 pm #

    @CCP “I think you know what my answer will be”
    If your answer is to maintain your present equity allocation even if the next ten years proves to be a bear equity market then your losses will compound because the fixed income return will decrease given portfolio rebalancing and the continued low fixed interest situation and your diversification will not be as good a buffer going forward as it is presently I think.

    I generally try to be at 95+% fixed income. With new monies I purchase equities in Oct./Nov., have stop loss orders and usually sell most equities in May but will sell earlier if any equity obtains a 10% yield. But I’ve had some years when I just bought more fixed income and no equities. I deal with inflation by living more simply. I deal with declining interest rates by saving more each year and spending less.

    This approach keeps my wife happy and a happy wife beats any portfolio even the Couch Potato one ;).

  6. Canadian Couch Potato October 7, 2011 at 7:10 pm #

    @Jon Evan: “A happy wife beats any portfolio.” Perhaps, but my Couch Potato portfolio is lower cost, lower maintenance, and more tax-efficient than my wife. :)

  7. Superior John October 8, 2011 at 9:01 am #

    @Jon E. You have a lifestyle and wife that probably combines to be a rarity these days. If the masses would have had this discipline of living within their means I think the econmy would be in better shape. The ‘pleasure me syndrome’ has led, and still is blindly leading many down the road of uncertainty.

  8. Taal October 8, 2011 at 11:17 am #

    Kind of on topic – regarding fixed income.

    Just had a look at PHN650, which holds Canadian inflation-Linked Bond (which are essentially very long term from what I gather) + some interest rate security.

    It seems it’s done very well in comparison to other bond funds over the last 6 months – close to 10% return verse 5% or so, even for long term.

    Anyone have any guesses at to why ?

    Also what sites do you use to compare bond fund performance, not sure if google finance, for example, takes the dividend payouts into account ?

    Thanks !

  9. Canadian Couch Potato October 8, 2011 at 12:42 pm #

    @Taal: Real-return bonds, as you point out, have very long maturities, which means they will rise in price when long-term interest rates fall. And the yields on long-term bonds have gone down this year: http://www.bankofcanada.ca/rates/interest-rates/canadian-bonds/

    Good point about checking bond fund performance on Google Finance: no, interest payments are not included in these price graphs, so the returns will be dramatically understated. The best place to check the performance of the overall bond markets is by looking at the performance of the relevant iShares ETF. For example, for short-term bonds, look at XSB; for long-tern bonds XLB; for real-return bonds XRB; for the overall bond market XBB. Just go to the iShares website, find the fund’s page and click the Performance tab.

  10. John October 8, 2011 at 3:38 pm #

    The last six months in Australia have been tough. I’ve had a 14% drop, but a bounce back of 3% on thurs/friday. I hold 40/60 bonds-stocks but still the loss is hard. This site and one Australian site are the only ones promoting ‘stay the course’. There are some big problems in Europe and the US. However jobs are high in Oztralia, and the economy is booming. Here, the sharemarket gets slammed with every bit of bad overseas news.

    At least I have a community of positive investors to fall back on. I can block out all the “Sell Sell Sell” on the news. And if that gets too hard, I just watch this video.
    http://www.zapiks.com/share/player.swf?autoStart=true&lang=en&file=52372

    Cheers,
    John.

  11. The Dividend Ninja October 8, 2011 at 11:05 pm #

    Nice post Dan, I really like this point:

    “Staying the course is not “doing nothing.” On the contrary, it’s doing something thoughtfully and productively rather than constantly reacting to the market…”

    Many times selling and repositioning you many win i.e. if you were smart and astute to sell all your stocks in May. Most of the time most of us will make the wrong decision, selling at the bottom or too early in a rising maret. Conversely many people have been missing the income opportunity from bonds. Trying to outguess the market is a losers game! Your bound to make a few too many wrong choices, that will really set you back over your wins. Stick with an Asset Allocation, rather than worrying about individual securities, or micro or macro economic changes.

    Cheers
    The Dividend Ninja

  12. knobert October 12, 2011 at 3:55 pm #

    Thank you for the analysis, my portfolio mirrors your numbers. We have seen some crazy market swings in VTI and VXUS but I bought most of mine when our dollar was at $1.05-$1.10. the currency exchange does not totally negate the losses in the market but having the bonds sure did!!

    Thanks again for the jumping off point into ETF and couch potato inveting.

  13. Ross October 16, 2011 at 12:38 pm #

    Hi Dan,

    I’m a newbie to your blog (love it so far BTW), and seeing the performance of the Complete Couch Potato model portfolio as of the end of Q3 for 2011 was interesting. Do you publish tracking results for all of your model portfolios? Apologies if you’re already doing this, but I haven’t been able to find it if so. I think it would be great if you could track quarterly and YTD performance for each portfolio and publish the results every quarter. Over time, this will give your readers a sense of both returns and volatility as market conditions change and help them to make decisions for their own portfolios.

  14. Canadian Couch Potato October 16, 2011 at 2:19 pm #

    @Ross: Glad you’re enjoying the blog. I don’t spend a lot of time calculating short-term performance results. I feel that it distracts investors from what’s important, which is sticking to a long-term strategy. I pay a lot of attention to tracking error (the best measure of how well the portfolios are doing their job) and do publish those results. I may start compiling annual returns for the portfolios, but certainly periods less than that are meaningless. In the case of this post, I was trying to demonstrate the benefit of diversification, which continues to get a bad rap. A diversified portfolio is holding up extremely well in this market turmoil.

    Here are some longer-term performance results:
    http://canadiancouchpotato.com/2011/04/18/the-couch-potatos-10-year-report-card/

    Have a look at the two or three posts after the report card one linked above. It’s important to compare the results to the alternatives. 4% annually over the decade may not sound good, but it was enough to trounce the vast majority of the alternatives.

  15. Michael Rosmer February 18, 2012 at 10:25 pm #

    As a firm opponent of diversification, I consider it diworsification in many cases I think there’s a base assumption in this argument that’s wrong, namely the focus on the short term over the long term. Warren Buffet is a great example of this, he buys companies he doesn’t need to look at in the short term. In the short term they might go up, they might go down, it doesn’t matter because long term they are going up and going up pretty consistently. It’s this obsession with quarterly earning, annual returns, etc. that causes problems. People panic because they’ve lost money, they get away from fairly simple principles and focus on all kinds of ideas that throw them off.

    So, your portfolio lost only 1.6% this year…who cares? It isn’t what happens this year that matters, it’s what happens in the bigger picture. This is the misnomer people tend to make about real estate. You’ll be in a poor real estate market such as the early 90s and be saying “look, the bubble burst, real estate is no good” but I ask you, what if you could purchase real estate today at early 90s prices? You’d be pretty happy right? The key is to pick investments that provide cashflow (such as dividend paying blue chip stocks such as in utility companies) that will go up over the long term and invest counter cyclically.

    What’s the problem with diversity? Yes, it will limit your losses, but it will also limit your gains. It’s easy to cry “diversification” in a down market when the average portfolio has lost a ton of value and you’ve only lost a bit. But then the market flips and you’re showing moderate gains when others are showing great gains and you’ve just entered into a net zero equation. Diversity leads you towards the average, the more diversified you are the closer you’ll be to the average. Real gains are created by being very focused around specific market inefficiencies and exploiting them. That might sound hard if you’re obsessed with market indicators but it is possible and relatively simple if you focus on the emotions of the market and then sold fundamentals in long term asset classes.

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