Some Advice for New Potatoes

March 5, 2012

One of the most gratifying things about writing this blog is getting emails from young people who are just getting started in Couch Potato investing. “Without you,” a 23-year-old wrote this week, “who knows what I would have continued to do with my money.” I wish I could say I got started that young.

New Potatoes are often full of questions about the ideal asset allocation (“Should I include 10% in emerging markets?”) and how they might save a few basis points by choosing Vanguard ETFs instead of the TD e-Series funds. But when it comes to new investors who are starting small, I think these decisions are almost immaterial.

If I could send one message to young people who are just beginning their investing journey, it would be this: stop worrying about squeezing out incrementally higher returns and concentrate on saving more money. Because when your portfolio is small, the size of your monthly contributions has a much a greater effect than your rate of return.

When savings are more important than costs

To illustrate this idea, let’s look at two investors at different stages of life. Christopher is in his early 20s and has just started his first full-time job. He’s saved $5,000 in his RRSP and plans to sock away another $100 a month. Christopher is trying to determine the perfect asset mix and keep his fees as low as possible. But what if instead of trying to optimize his portfolio he instead made an effort to increase his monthly contribution to $150, or even $200?

Starting value $5,000, contributions for 10 years
Rate of return $100/month $150/month $200/month
1.5% $18,151 $24,464 $31,717
2% $19,400 $26,047 $32,694
3% $20,756 $27,760 $34,765
4% $22,228 $29,615 $37,002
5% $23,828 $31,624 $39,421
6% $25,567 $33,802 $42,037
7% $27,458 $36,162 $44,867
8% $29,515 $38,723 $47,931
9% $31,753 $41,502 $51,250

As you can see in the table, at $100 a month and a rip-roaring annual return of 9%, Christopher would have $31,753 after 10 years. But if he increased his contribution by 50% to $150 a month, he would only have to earn 5% to wind up with the same amount. If he were able to dig deep and double his monthly contribution to $200, he wouldn’t even have to take any market risk: a savings account earning just 1.5% would leave him with an almost identical $31,717.

It seems clear that at this stage of his investing career, Christopher is far better off finding an extra $50 to $100 in his budget rather than trying to get an extra percentage point out of his portfolio’s performance—let alone 10 or 20 basis points by choosing ETFs instead of index mutual funds.

When low costs are paramount

Now let’s consider Nicole, who is in her 50s and has accumulated $200,000. Nicole is well along in her career and is now contributing $500 a month to her account. She wants to get an extra 1% out of her portfolio to ensure that she retires with a comfortable nest egg, and she is considering making some changes that will lower her costs by that amount. She wants to compare this cost savings to the alternative of raising her monthly contribution to $750, or even $1,000:

Starting value $200,000, contributions for 10 years
Rate of return $500/month $750/month $1,000/month
4% $372,036 $408,972 $455,907
5% $407,367 $446,349 $485,331
6% $446,229 $487,403 $528,578
7% $488,980 $532,503 $576,027
8% $536,011 $582,052 $628,093

Because Nicole’s portfolio is so much larger than Christopher’s, lower costs (or higher investment returns) now mean thousands of dollars every year. Increasing her returns by one percentage point over 10 years would have a greater effect than increasing her monthly contribution by 50%. And two percentage points—the approximate MER difference between a typical portfolio of actively managed mutual funds and ETFs—accomplishes more than doubling her contribution. It adds up to about $100,000 over 10 years.

Keeping costs low and choosing an appropriate target rate of return are important at every age. But the truth is, if you’re a young investor these factors matter a lot less than you think. In your 20s, it’s better to focus on spending less than you make and saving the difference. Once you have built significant wealth—and you will—then those basis points become much more important. Lay a foundation of good habits and by the time you enter your peak earning years you’ll be primed for success.

{ 66 comments… read them below or add one }

Canadian Couch Potato March 7, 2012 at 11:39 pm

@newbie: Yes, you will still pay a withholding tax on US dividends if the ETF or index fund is held in a TFSA. Withholding taxes are levied by the US government, which does not recognize the TFSA’s tax-free status. (However, the US and Canada have a tax treaty making RRSPs exempt from this tax.)

Note, however, that this does not apply to capital gains. These are not taxable in a TFSA.

Canadian Couch Potato March 8, 2012 at 12:34 pm

@SterlingF and Marc: Here’s the answer from RBC. To clarify the first point, early redemption fees can be charged by the brokerage or by the funds themselves. RBC Direct Investing (the brokerage) does not charge early redemption fees, but RBC Asset Management (the index fund provider) does. It should be noted that other brokerages and other index fund providers will have different rules. These rules are quite a bit more generous than most.

There are two aspects to your question. The following are the two parts to your question and the answers are directly below:

1: Does RBC Direct Investing charge any early redemption fee and how it works?

RBC Direct Investing does not charge any early redemption fee (irrespective of how many days the fund was held). Fund companies may charge their early redemption fees per their policies.

2: Does RBC Asset Management charge any early redemption fee and how it works?

The 2% charge is automatic. The 1% charge is at our discretion and is generally not applied.

Short-term trading fees
A fee of two per cent of the amount redeemed or switched will be charged if you invest in units of a fund (excluding money market funds) for a seven-day period or less. A one per cent fee may apply for amounts redeemed or switched if you invest in units of a fund (excluding money market funds and the RBC Canadian Short-Term Income Fund) for more than seven days but less than or equal to 30 days.
Fees charged will be paid directly to the fund, and are designed to deter excessive trading and offset its associated costs. For the purposes of determining whether the fee applies, we will consider the units that were held the longest to be the units which are redeemed first. The fee will not apply in certain circumstances, including:
- pre-authorized, auto switch, or systematic withdrawal plans;
- redemptions of units purchased by the reinvestment of distributions;
- reclassification of units from one series to another series of the same fund; or
- redemptions initiated by RBC GAM, another RBC Fund or a mutual fund where redemption notice requirements have been established by RBC GAM.

Many thanks to RBC for the clear and prompt reply.

Mark in Kingston March 10, 2012 at 1:02 pm

What??? That is the worst advice I’ve ever heard. Obviously Chris should be trying to do both. Get the best returns he can and save his money. In your example he’d have 50k+ if he could do both. They are mutually exclusive. Chris should focus more on eating vegtables and less on savings money… Does that not sound stupid too. He should do both!!

Canadian Couch Potato March 10, 2012 at 1:16 pm

@Mark: I’d appreciate it if you’d keep comments more respectful. I’ve never claimed that it’s impossible to maximize your savings and minimize costs. But if you received the amount of investor email that I do, you might have a different perspective. You might be surprised how many young investors pay little or no attention to saving, choosing instead to focus all of their energy on portfolio optimization that will have very little effect on their results. It’s also important to remember that Chris can’t just go out and get 9% returns. We cannot control our rate of return, but we can control our contribution amounts.

Mark in Kingston March 10, 2012 at 2:22 pm

@Canadian Couch Potato. I think you are contradicting yourself. “But what if instead of trying to optimize his portfolio…” (from the article) (implies he can change his rate of return) ” We cannot control our rate of return”(from your comment)

“Lay a foundation of good habits and by the time you enter your peak earning years you’ll be primed for success.” This I agree with. Make good habits of maximizing returns AND savings.

I agree savings is important, but it is completely unrelated to maximizing return.

I didn’t mean to offend and I apologize.

Canadian Couch Potato March 10, 2012 at 2:47 pm

@Mark: Thanks for the reply. You can control expected returns by tweaking your asset allocation and by lowering your costs, and this is what I meant by portfolio optimization. But unless you stick to GICs and the like, you cannot know your absolute rate of return. You can tilt more of your portfolio to stocks or reduce your costs by 50 basis points, and both of these actions raise your expected returns, but they offer no guarantees. Saving more money has no effect on your expected returns, but it does guarantee that you will end up with more money.

I have spoken with many financial planners and advisors who have told me they regularly deal with clients who are so focused on their investment returns that they forget that if you’re not saving enough money, nothing else really matters. Very few people get wealthy because they are outstanding investors. They’re more likely to accumulate wealth by spending a lot less than they earn, and then wise investing allows them to preserve and grow that wealth.

Mark in Kingston March 10, 2012 at 2:54 pm

I just would have worded more like that in the article instead of saying that people should “stop worrying about squeezing out incrementally higher returns”

Instead say, worry about incrementally higher returns but it is also important to save more money.

I’ve read around the site some more. It looks very good.

Francis March 10, 2012 at 8:16 pm

I would want to if there a way to build a good portfolio with all the free trade ETF availible on virtual brooker (100 ETF), Qtrade(50 ETF) and scotia Itrade(40 ETF). If yes you should add this new portfolios to your list and call the The ComFree Patato ;)

Canadian Couch Potato March 11, 2012 at 9:51 am

@Francis: In general, I don’t recommend making this the primary driver of your decision. The lineup of free ETFs at Virtual Brokers, iTrade and Qtrade is quite limited, and most of the products are narrow sector ETFs, commodity ETFs, etc., with few options for the core asset classes. Claymore’s ETFs are well represented, but many of these funds have higher MERs than index mutual funds. So it makes little sense to use these funds simply because they trade without commissions. If you are a believer in fundamental indexing, however, then this is a good opportunity.

In terms of core asset classes, you might consider CLF and CBO for short-term bonds, HXT and XMD for Canadian equities, and HXS for US stocks (as long as you don’t mind currency hedging).

Marc March 20, 2012 at 10:33 pm

@Canadian Couch Potato: thank you so much for following up with the reply from RBC. It sounds like the plan will work: use an index mutual fund as a “bucket” to collect monthly contributions without incurring fees and then every year “empty the bucket” into ETFs (allocating as required to balance the portfolio) making sure to leave enough units in the mutual fund to avoid the early redemption on the last month’s contributions.

Canadian Couch Potato March 20, 2012 at 11:02 pm

@Marc: You’re welcome, and good luck with the plan.

Kevin April 9, 2013 at 8:57 pm

@CCP – was digging through your old posts – your site is truly a “gold mine” of information. You certainly convey your passion for this, and it is quite motivating. Reminds me of the book “The Richest Man in Babylon” which is a great read for anyone trying to build wealth.

Now for a real question – I just saw your comments on iTrade and Virtual Brokers’ free ETF trades, but with limited selection. Fast forward to today, and Questrade is now offering free purchases for ANY North American ETF. Do you have any thoughts on this? Is this not a great alternative to the TD E-series funds as people can contribute regularly without taking a hit? (I think ECN fees still apply though..)

Thoughts?

Canadian Couch Potato April 10, 2013 at 12:43 am

@Kevin: Questrade is probably a good option for investors who are bent on ETFs, but in my opinion the TD e-Series funds are still the best place for small accounts:
http://canadiancouchpotato.com/2013/02/19/why-index-mutual-funds-still-have-a-place/

Matt March 12, 2014 at 8:11 am

I am 25 and working as a an engineer. I have about 15k saved right now, and can put away almost 40k a year, which I have excess of all my living expenses. I was looking at opening a TFSA and filling it with index funds and capping it each year, as well as investing the rest of this excess money each year.

If I would be looking at using this money in the next year or two to purchase a new car, and maybe 5 years down the road purchase a house. Can a TFAS retroactively be filled (can I fill it for 2013/2012/2011 etc), such that the rest I can put into a RSP (the amount in a TFSA would be more than enough for a car if I can do this), or would I have to look at filling up the TFSA each year and just setting up a mutual fund account if I’ll need to withdraw it in the next year or two for a car. I was looking to fill these accounts with index funds (TD e series or ING).

Thank you for this blog and articles. I have a learned a lot reading these posts, and it has really motivated to invest my money instead of letting it sit stagnant in a ridiculous low interest savings account.

Canadian Couch Potato March 12, 2014 at 8:28 am

@Matt: Yes, you can retroactively fill a TFSA. Even if you have never opened an account, your contribution started accumulating in 2009, when the TFSA was launched, as long as you were 18 years old. So in your case, you should have $31,000 of room if you have never made any past contributions.

The bigger issue is your suggested strategy. If you plan to use the money in the next year or two (or even the next five), it should not be invested in index funds (except perhaps a short-term bond fund). Stocks and (many) bonds are long-term investments that can lose value over shorter periods. The only appropriate place to stash savings for one to five years is a savings account or GICs.

http://canadiancouchpotato.com/2010/08/16/lunch-is-still-not-free-even-if-its-potatoes/
http://canadiancouchpotato.com/2010/11/10/ready-willing-and-able-to-take-risk/

Rachel April 17, 2014 at 11:36 pm

I just signed up for a questrade account. I am still trying to understand why one shouldn’t invest in ETFs with less than $50,000? Is it ok to start with them since it doesn’t cost anything to buy them and if I plan on getting my investments to that amount in the next few years?

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