Why Your Problem Is Not Your Funds

In Monday’s post I looked at “smart beta,” which promises to outperform cap-weighted indexing strategies. I’m frequently asked if I think Couch Potato investors should dump their traditional index funds in favour of these tempting alternatives. Here’s why my answer is no.

I could rhyme off technical reasons for being skeptical about the outperformance of alternative indexes: the research ignores costs and taxes, the strategies may not work in the future, and so on. But I won’t go down that road, because the most important reason is not technical, but behavioral.

Everything beats the market—except investors

To recap, two recent papers from Cass Business School in London looked at US stocks from 1968 through 2011, a period when a cap-weighted portfolio would have returned 9.4% annually. (Canadian stocks had an almost identical return over those 43 years.) The researchers examined 13 alternative strategies—which favoured value stocks, small-cap stocks or low-volatility stocks—and found all of them outperformed, with returns between 9.8% and 11.5%.

For many people, the takeaway from these findings is, “I should use alternative indexes, because I can beat the market by a point or two.” My reaction is different: I want to know how many investors earned even 9.4%.

I touched on this idea back in May when I asked why there are countless strategies that beat the market, but so few investors who can make that claim. There’s little data on the performance of individual investors, though it’s safe to say only a tiny minority are likely to outperform a simple cap-weighted benchmark over any period longer than five years. That’s my biggest concern about being seduced by smart beta: it encourages investors to focus on beating the market even though most can’t even match it.

The problem is not cap-weighting

Has there ever been an investor who fell short of his financial goals because he earned only the returns of a cap-weighted portfolio? “I did everything right,” we’d hear him lament. “I paid down my debt, lived frugally, and saved regularly. I built a diversified, low-cost, tax-efficient portfolio of index funds appropriate to my time horizon and risk profile. When stocks plunged I kept my head and stayed invested—I even rebalanced to get back to my targets. I ignored all forecasters and swore off market timing. Now look what happened: my cap-weighted funds underperformed the hypothetical backtested performance of several alternative strategies. Now I can’t have the retirement I hoped for.”

There are many reasons investors fail, but the shortcomings of cap-weighted index funds are not among them. The search for smart beta makes me think of an out-of-shape guy with a poor diet who’s convinced his biggest problem is he’s wearing the wrong brand of running shoes.

Check your priorities

So before you think alternative indexes will have a meaningful impact on your financial life, ask yourself these questions:

Do I have any consumer debt? Student loans, car loans, credit cards, a line of credit from your last reno or vacation: if you have even a dollar of non-mortgage debt, it may not even make sense for you to be investing, let alone trying to beat the market.

Am I saving as much as I can? The best way to grow your portfolio is not to seek a market-beating strategy: it’s to increase your contributions. Instead of hoping to outperform traditional index funds by 1%, try increasing your annual savings rate by 1%. This will almost certainly have a more dramatic effect, especially if your portfolio is small. It also comes with a 100% guarantee of success.

Do I get market returns now? Calculate your personal rate of return over the last five years and compare it to a comparable portfolio of cap-weighted ETFs. If you lagged even that simple portfolio, why are you worried about trying to beat the market? (Obviously this doesn’t apply if you are already a thoroughbred Couch Potato, but hardly anyone is.)

Will I really stick to one alternative? If you’re using cap-weighted funds now and you’re prepared to dump them, do you really believe you won’t switch gears again when the next new alternative comes along? The value and small-cap premiums are real, but they’re elusive: there will always be multi-year periods when these factors lag a cap-weighted portfolio. Are you sure you’ll wait these out?

As I’ve written before, I’m agnostic about alternative indexing strategies. It’s not that they’re bogus: it’s that even if executed perfectly they can’t do more than provide incrementally better returns. And by spending so much effort trying to collecting a few drops of rainwater, many investors are ignoring much bigger leaks in their financial lives.

31 Responses to Why Your Problem Is Not Your Funds

  1. Michael James July 18, 2013 at 9:46 am #

    I like the way this piece starts very calmly, builds to the point of almost crossing over into a rant with the running shoes bit, and winds back down again. Good message and well delivered.

  2. Canadian Couch Potato July 18, 2013 at 10:19 am #

    @Mike: Me, rant? Never.

  3. Mike Holman July 18, 2013 at 11:29 am #

    It’s not the quality of the running shoes that matters – it’s how they look. Everyone knows that!

    Great piece. It’s so easy to get fixated on some small aspect of personal finance like shaving 0.0004% off your portfolio MER which makes no difference at all and ignoring issues that do matter like saving rates etc.

  4. Kevin Kane July 18, 2013 at 12:38 pm #

    Dan, brilliant. You put things in perspective.

    And even if we have addressed the bigger leaks in our financial lives — such as our debt or a savings rate that’s less than 50% of our take-home pay — is it worth spending our time to research and execute these alternative indexing strategies? We could instead use that time to earn more money to invest as a Couch Potato, or to just have fun.

    It’s amazing how biased we are toward finding new and complex “solutions” when we already have a simple Couch Potato one that works damned well if we’d just have the discipline to follow it and leave well enough alone!

  5. CheapSkater July 18, 2013 at 12:47 pm #

    The first paragraph after “The problem is not cap-weighting” is golden! I enjoyed the post.

  6. Gordon July 18, 2013 at 12:54 pm #

    Thank you Dan, very well written article. Calming voice of sanity in stormy waters of investment universum. Forget exotic ideas, stick with the basics, don’t be greedy, don’t be fearful. Steady pace wins the race.

  7. PeterH July 18, 2013 at 3:04 pm #

    To elaborate on your metaphor, changing shoes is always risky. A month ago, while training for a marathon, I switched to shoes with a lower heel and more cushioning in the forefoot. I had good reasons for doing so but within a week had to stop running due to a calf muscle injury. At least I had hedged by postponing payment of the registration fee. Thanks for another great post.

  8. Dale@Streetwise July 18, 2013 at 3:12 pm #

    Love the running shoe line. Nice writing Dan. You sure can spin dem metaphors. Ha.

  9. Canadian Couch Potato July 18, 2013 at 3:25 pm #

    @Kevin: It’s true that we seem hard-wired to resist simple solutions. I didn’t really appreciate this until I started working directly with investors:
    http://canadiancouchpotato.com/2013/04/29/the-power-of-simple-portfolios/

    @PeterH: I love that you have an example that actually turns my metaphor into something literal!

  10. Mike Holman July 18, 2013 at 3:47 pm #

    PeterH – How do you know the injury was caused by the new shoes? It could have been a coincidence.

  11. PeterH July 18, 2013 at 6:49 pm #

    @Mike Holman: The shoes were a contributing factor. When running, my forefoot strikes the ground first, followed by the heel. The lower shoe heel resulted in more stretching of the calf muscles, which became increasingly sore over several runs. This condition was then exacerbated by an awkward landing from a small jump. Looking at the big picture, however, I am inclined to blame the injury on greenhouse gas emissions, leading to climate change, including an extreme rain fall event in Alberta, resulting in some flooding in Edmonton (nothing compared with Calgary), requiring a detour from my running path, leading inevitably to that tragic jump back onto the path.

  12. ACMZ July 18, 2013 at 8:35 pm #

    Nice piece Dan,
    In my situation, I started with the Uber Tuber porfolio and converted it to the Complete couch potato portfolio for this exact reason of simplicity after about a year. A simple plan is much easier to follow. Mind you easier does not necessarily mean easy.
    Thanks Dan.
    Andre

  13. Noel July 18, 2013 at 9:44 pm #

    Could have taken the words right out of my mouth. As with many things in life, more than half the battle is just showing up, ie in this case, creating the index portfolio, tax allocation, investing the $, rebalancing, regular investing regardless of what the market does, etc.

  14. JSR July 18, 2013 at 11:29 pm #

    Dan usually is very well deserving of the praise he gets from his readers. In this case, I am not so sure.

    I fail to see the connection between investors not having their financial priorities right about paying off consumer debt, etc., and a question about which passively held investment ETFs will serve an investor best over the long term. The evidence, both intuitive and empirical, is against cap-weighted etfs/indexes. As well, behaviourally, there is no reason to believe that people are any less likely to tinker with their commitments to cap weighted couch potato portfolios to their disadvantage than they are with other etfs that weight their holdings differently.

    The real lesson that is emerging is to choose an appropriate asset allocation of cheap highly liquid equal weighted or fundamentally weighted indexes, or a mix of various asset classes — and stick to them like a good couch potato. Advice about the former (what ones to choose and explanations of how they effectively add the advantages of small cap and value stocks and avoid the disadvantages of cap-weighted etfs) and encouragement about the latter (don’t be distracted by the noise of the stock market, add and rebalance according to your allocations) would make for better couch potato. A .5-2% increase in average returns compounded over time should provide some incentive too, just as it did for many of us who followed Dan’s advice and gave up mutual funds. This is not about beating the market. It is about efficient use of ETF instruments. Of course, all couch potato investors still have to make sure they are not ruining their financial lives by not paying down their credit card debts, etc. But that is another topic and a different blog…

  15. Gupta July 19, 2013 at 4:51 am #

    Uhhh … just a friendly reminder of some apparently taboo subjects at The Temple of Couch:

    Volatility, Risk/Return, Time Horizons, Investor Mortality, Forced Sells at Inopportune Time(s), Correlation Matrices, Opportunity Costs, Utility Functions …

  16. JW July 19, 2013 at 7:58 am #

    Good post Dan,

    I’m interested to see you response to JSR.

    I flip flopped about what strategy to follow when I first started investing (ETF’s based on CCP’s model portfolio’s or Norm Rothery’s All-Stars). They only think I knew for certain is that I wanted one (1) strategy I could follow for life. I chose ETF’s because Norm will die one day (no more stock picks provided to me) and I questioned if I would stay with his strategy if it lost to the market for more than a year or two. There were other factors but those two where the main reasons.

    As for other forms of ETF’s (Fundamental, value, etc), I think about them but soon say screw it. The Couch Potato strategy has made me lazy and I’m grateful for that.

  17. Canadian Couch Potato July 19, 2013 at 8:21 am #

    @JW and JSR: I accept that some people don’t share my view about this. I’ll just comment on one of JSR’s comments: “Behaviourally, there is no reason to believe that people are any less likely to tinker with their commitments to cap weighted couch potato portfolios to their disadvantage than they are with other etfs that weight their holdings differently.”

    I can’t prove this, but in my experience there are two broad categories of index investors. The first recognizes that broad diversification, low cost and discipline are what matter most, and that’s enough for them. The second recognizes the value of these three things but is constantly searching for something better. There might be something better, I don’t know. But this group will never be content with their current strategy, and it’s the constant search that leads them them to tinker.

    If someone came to me and said they’ve been using some specific alternative indexing strategy in a disciplined way for five years—especially a strategy that lagged the market for some period—I would encourage them to keep it up. But I have never met one. Usually what I see is people who are dipping a toe into this and that, trying to figure out the optimal strategy, putting a lot of value on recent performance and hypothetical backtests, poring over every research paper that promises some improvement on traditional indexes, etc. I do feel these investors are far more prone to stray from what’s important.

  18. HarveyM July 19, 2013 at 1:54 pm #

    There is no superior weighting methodology that holds the secret to best outperformance in the longer term. Cap weighting will perform well in certain environments, while equal weighting will lead the way in other periods. The same is true for all the other strategies out there; dividend-weighted ETFs enjoyed a great 2011 as interest in stocks offering meaningful current returns surged due to low fixed income returns. But that will change as interest rates move up. I think that weighting methodologies simply reflect a tilt towards one factor or another, whether it be small cap stocks, value stocks, or leveraged stocks. There are environments in which each of those methodologies will perform well, and others in which they will struggle. BUT, over the longer term will they not balance out into similar returns provided that one sticks it out? Investing, is over the long term and one’s behaviour needs to be focused there and I’m with Dan. Discipline is more important than which index!

  19. Matt Becker July 19, 2013 at 5:06 pm #

    Oh wow, that middle part gave me a laugh. It’s almost sad that it’s so funny. I really don’t think most people ever stop to think why they’re so focused on beating the market. If they did, they would probably realize it was a silly goal and find something fun and constructive to do with their time. Your response to JSW is spot on as well. It’s not a belief that cap-weighted is empirically and always the best way to go. It’s the reality that constantly trying to find the newest best way of doing things, even if they’re “passive” approaches, is in my mind at least no different than active management. It’s a focus on the wrong priorities and will likely lead to the same long-term underperformance that we see from active management.

  20. dale@streetwise July 20, 2013 at 8:20 am #

    I would add that i did outperform the market thanks to small cap and emerging markets. I even had the luck to sell at the right time. I will continuw to outperform the market moving forward with my equity component due to dividend growth strategy. While many make mistakes we should remember that it is not impossible to outperform the market if one demonstrates patience and adopts a proven strategy. In addition to DG also happy to use Streetwise Portfolios for the diversification discipline.

  21. Andrew July 23, 2013 at 8:41 am #

    This is a really smart analysis and as usual the comments are interesting and useful. Esp. like the questions about debt and saving rate.
    Comment:
    I know someone who is using an algorithmic strategy in their TFSA based on momentum factors. It is an interesting strategy, particularly since it takes advantage of the tax free nature of the TFSA plus it uses commission free ETFs because it involves rebalancing every month and about 60 trades a year. However it also requires discipline. On paper based on past data it looks great – x% CAGR, Sharpe 1.5?, theoretical doubling of capital in 6-10 years etc etc…. but practically is another thing because every month on the first day it requires a particular set of actions plus times when the trades will be losing as it only has 60% or so winning months. I wonder if the strategy will be implemented over time.

    Interestingly it might be easier to overcome behavioural issues (soon according to what I am reading) when our personal computers will have such advanced macros functions that mechanical strategies such as this can be automated by the average person. The computer will gather the data, crunch the numbers and execute the strategy on time like clockwork taking the individual out of the equation. I saw that this particular strategy is already partly automated as there is a minimum variance algorithm spreadsheet someone posted that draws data from Yahoo finance and calculates the portfolio weights just by entering the ticker.

  22. Brian Poncelet,CFP March 14, 2014 at 2:53 pm #

    I can across a story from USA today. March 14th. The reporter John Waggoner
    reported the S& P 500 index returned 3.5% from March 2000 to 2014!

    Remember this assumes 0% fees. If you factor in inflation and taxes the return is below zero!

    Brian
    PS. this means in retirement you need several strategies

  23. Canadian Couch Potato March 15, 2014 at 10:37 pm #

    @Brian: The first point here is that the particular period chosen is the worst one for US stocks on record. As of the end of January 2014, the 15-year annualized return on the S&P 500 was indeed very low: 4.2%. But the 10-year return was 6.8% and the 20-year return was 8.9%. So you likely did just fine unless you happened to move from cash to 100% US stocks on the day the before dot-com bubble burst and never contributed another dime.

    The other point I’d make is that this is an argument for diversification across multiple asset classes, including bonds and foreign stocks, and regular rebalancing. It isn’t an argument for using “smart beta” strategies to improve your returns on US stocks or any other individual asset class.

  24. Noel March 15, 2014 at 11:21 pm #

    @Brian Poncelet, CFP: You need to sharpen your pencil. I only have the numbers right now to the beginning of January 2014 when the S&P 500 was at 1822.36 vs 1845.73 at the beginning of March 2014, but the 24.37 point difference is not going to affect the results much over a 166 month period vs a 168 month period.

    Here are the annualized results for the period between March 2000 to January 2014:

    Not adjusted for inflation:

    Index Rate of Return without Dividend Reinvestment: +1.71%
    Index Rate of Return with Full Dividend Reinvestment: +3.62%

    Adjusted for the inflation rate of 2.28% during this period:

    Index Rate of Return without Dividend Reinvestment: -0.56%
    Index Rate of Return with Full Dividend Reinvestment: +1.31%

    The taxes obviously cannot reduce the return with full dividend reinvestment to below zero.

    And no this does not mean in retirement you need several strategies. Aside from the fact that, as Dan notes, ‘the chosen period was the worst one for US stocks on record’ this does not change the wisdom that Dan has provided on this website. What you only ever need is one strategy. Dan can write it better than me, but that strategy is to determine your risk profile (need, ability & desire to accept risk), employ a diversified investment strategy to reflect this risk profile, allocate your investments in a tax-efficient manner, invest on a regular basis no matter what the market does, re-balance your investments as necessary to maintain your target allocations within pre-defined limits, employ tax-loss harvesting and then review and adjust your investment strategy (which you should have in written form as an Investment Policy Statement that you can review when you get weak during market gyrations) every 5 years or so to reflect your needs as you age.

    That’s it. One simple strategy that takes a few hours a year to manage once set up DIY or by PWL using their fixed one-time fee service and that can easily be maintained DIY or by employing a firm like PWL to manage it all for a reasonable asset-based fee.

  25. Brian Poncelet,CFP March 17, 2014 at 6:28 pm #

    @ Candiancouchpotato,

    Thanks for letting me post my thoughts here. I tried to do the same on Moneysense but I guess Jonathan is away or they lost it.

    A good tool to look at is Moneychip (see link below)

    Go to http://www.moneychimp.com/features/market_cagr.htm

    Yes I know the this was a bad period but this is what just happened?!

    Here is the link to the USA today story:
    http://www.usatoday.com/story/money/columnist/waggoner/2014/03/13/lessons-from-14-years-of-misery/6381747/

    My point is when you factor in inflation & taxes the returns are brutal.
    Hey, if the calculations are wrong, for the above let me know.

    Brian

  26. Canadian Couch Potato March 17, 2014 at 7:35 pm #

    @Brian: Always happy to open up a debate. I don’t dispute the calculations, only the lesson you may have drawn from them. It was a brutal 14 years for the S&P 500, but I don’t think the situation is improved by replacing cap-weighted indexes with “smart beta” strategies. I think the solution is to diversify globally (the S&P 500 is US large caps only), contribute regularly, rebalance periodically and take a longer view.

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