A Reality Check for Couch Potatoes

The investment industry never misses an opportunity to take credit for outstanding performance. In fact, many mutual fund providers crow about their returns even when they’re mediocre or downright bad compared to appropriate benchmarks. One of my recent favorites was an ad that read: “Over the 1-year period, 91% of Trimark global equity funds returned 10% or more.” This is touted as an impressive accomplishment, but during this one-year period (ending September 30, 2013), the MSCI World Index was up over 21%. An actively managed global equity fund that returned even 15% would have been an absolute dog.

The recent performance of my model portfolios has been excellent: in 2013, the humble Global Couch Potato returned more than 15%, and over the last five years, a balanced index portfolio could easily have achieved 10% annualized returns. But if you’re a passive investor, it’s important to understand this performance simply reflects that we’ve enjoyed a five-year bull market in stocks—not to mention five years of bond returns that were higher than most people expected. Unlike the proud fund managers at Trimark, indexers shouldn’t take credit personally—except to pat themselves on the back for building a diversified portfolio and staying invested.

That’s why I’m uneasy when I receive e-mails from readers who tell me how pleased they are with the results of Couch Potato portfolios they’ve built in the last couple of years. Obviously I’m happy to hear from folks who have embraced indexing, but I worry their expectations may be unrealistic if they believe recent performance is typical. It’s hard not to love indexing when equity markets are soaring to new heights: it’s much harder to maintain confidence during a brutal bear market. And it’s been a while since we’ve seen one of those.

One reader, for example, recently wrote to tell me he adopted the Global Couch Potato in 2011, and since then “returns have consistently been very good compared to the money market funds and GICs I had invested in up to that time.” That’s certainly true: the Global Couch Potato has had just three negative months since October 2011. But this is highly unusual: balanced portfolios are historically much more volatile than that. Investors accustomed to high returns and low volatility are likely to be blindsided by the next correction. Unless they understand what to expect from an index fund portfolio (hint: it will plunge along with the markets) they’re likely to give up on the strategy at precisely the wrong time, declaring it “doesn’t work anymore.”

The view from the other side

Back in the summer of 2010, I heard from investors who had a completely different story to tell. One shared a story about building a Couch Potato portfolio in early 2007: some three years later, her returns were negative. Not surprisingly, she regretted her decision and wondered if the strategy was broken. It wasn’t, obviously. She just happened to have the bad luck of building her portfolio near the peak of a bull market, only to get run over by the global financial crisis that followed a year-and-a-half later.

Had this investor rebalanced and stuck with her strategy, she would have seen her portfolio recover dramatically during the next three-and-a-half years. But I would not be surprised if she bailed out in frustration, because her expectations were unrealistic. “I had read that gains were steady with the Couch Potato strategy,” she wrote, “but do not see that with my portfolio.”

So let’s be clear: if you’re investing in a portfolio of stocks and bonds, your gains will never be consistent or “steady” for very long. On the contrary, you’ll suffer through a series of dreadful, gut-wrenching months alternating with exciting, hard-charging bull markets. There will be periods when indexing feels like the greatest investment strategy ever devised, and others when your emotional brain is telling you only a moron would do such a thing. You need to be prepared to endure the latter, or you won’t be around to enjoy the former.

Building a low-cost, broadly diversified portfolio is the right thing to do. Just make sure you’re not doing the right thing for the wrong reasons.

69 Responses to A Reality Check for Couch Potatoes

  1. EH January 29, 2014 at 12:50 pm #

    Great post. Your posts are always educational and accurate, and I think this is a great reminder to people. No matter how good your index investment strategy, it can be completely ruined by trying to time the market. Selling securities after a bear market, or sitting on the sidelines holding on to cash during a bull market waiting for a downturn are sure ways to destroy your long term returns.

  2. Mark January 29, 2014 at 1:55 pm #

    The recent run up in stocks is more worrying because it has gone on so long. I feel extremely nervous at the moment and am really hoping for a bit of a correction so that sanity can be returned to the market. I’ve got a balanced portfolio of bonds and equities and my rebalancing into bonds has been pretty large even though it only makes up 35% of my portfolio. I really can’t wait for the day that equities go down and I can start rebalancing the other way!

  3. Neil January 29, 2014 at 3:13 pm #

    @Oldie: The return from paying down the mortgage is fixed. The return from bonds are not fixed: you get the yield, but you can also realize changes in net asset value (market price). That increases bond returns during equity downturns, providing more of a cushion than “X”.

    That said, the effect I was thinking about is primarily psychological. Unless you remember the amount you’ve pre-paid on the mortgage, you’re more likely to just view your balance on your investment statement tanking in isolation and react to that.

  4. Carlos January 29, 2014 at 5:00 pm #

    What a great read! My question, as an aspiring couch potatoe investor would be whether to enter the market now or wait for some sign of weakness? And if anyone recommends the latter, now that the market seems to be cooling off (after the sell off last Friday and the fed’s announcement to scale back QE further) is it a good time to start with an indexing strategy?

  5. Andrew January 29, 2014 at 5:08 pm #

    Mike D.
    I would not classify paying down a mortgage as a guaranteed return. If you bought a house in my market in 1989 and paid the mortgage for five years you would have been down about 29% by 1994. It also took 19 years for the market to recover in real return terms.
    I think its dangerous to base a retirement plan on the value of ones house. The real return of houses over very long periods is basically zero as houses depreciate with wear and tear.

    People often forget to include all the money they put into maintaining and upgrading their house over time in their calculation of its net return, and they also forget to do the calculation in inflation adjusted terms. If you look at charts of house prices over time the last few decades seem anomalous and it depends entirely on your local market conditions, demographics etc. What are the projections of house values as baby boomers downsize?

    I have seen the records of the prices for sale of my 100 year old house over the past century and for the first few decades of its existence it was a depreciating asset (its price did not change and the owners had to spend on keeping it up).

  6. Brian G January 29, 2014 at 5:38 pm #

    @Andrew. I think you are muddying the waters by mixing house returns vs. value of paying down a debt. If you own a house, whether you pay down the mortgage or not you’re still along for the ride. Whether the price of a house goes up or down and whether you have to maintain it if the same in both situations.

    So now the question is if you limit the discussion to whether I should pay down a mortgage OR invest, paying down a mortgage will almost always put you in a better situation down the road than if you invested because of the simple math involved.

  7. Brian G January 29, 2014 at 5:58 pm #

    Also, another thought. Any debt in a household portfolio is a form of leverage, don’t forget that you are taking on additional risk when you hold debt and a risky investment portfolio. Here are some simple examples to demonstrate:

    Imagine you have a $5,000 loan and $10,000 in investments. Your net worth is $5000. Now suppose your investments drop by 10%. Now you have a $5000 loan and $9,000 investments. Your net worth is now $4000 which is a 20% drop of your net worth! You have 2 times leverage whether you knew it or not.

    Suppose instead, you paid off your loan and had $5000 in investments with no debt. Your net worth is still $5000. Now suppose your investments drop by 10%. You now have $4500 total which is a 10% drop of your net worth. No debt = no leverage.

    Just something additional to consider.

  8. Oldie January 30, 2014 at 1:30 am #

    @Andrew: I’m with Brian G and his opinion that you’re muddying the waters between the separate issues of house returns and that of simple paying out of debt. However I think the choice between paying down the mortgage or applying towards your portfolio is far from clear-cut, and I’m prepared to consider the merits of both sides. I have pointed out that cash in the portfolio is still cash based on debt, as Brian G has cautioned. That said, my understanding was that the cash in the investment portfolio was to stay as cash or income, i.e. bonds so it would stay in the same asset category, not to be allocated to equities except in the special case of re-balancing, so applying the funds to the investment portfolio under those conditions would not be unreasonably risky, would it?

  9. Brian G January 30, 2014 at 2:01 am #

    @Oldie, a house mortgage in Canada and a bond fund/ETF are not the same asset class. The contracts are often quite different and thus they behave differently.

    Debt creates leverage in a family portfolio no matter how you slice it. In my previous post example, replace the word “investment” with “bond” and it still applies. Bonds are not risk free and can still go up or down in value (e.g. interest rate risk, default risk, inflation risk, etc.). Leverage will amplify the risk.

    You could not pay down the debt and invest in a risk free asset like cash or a T-Bill, but then I would ask why would you do that when after taxes and inflation, currently you’ll be loosing purchasing power as you hold the risk free asset vs. paying 3+% interest on the mortgage. That 3+% differential is fairly substantial. Also, if you are making over payments on your mortgage those go directly to reducing the principal… therefore lowering the debt/leverage.

    A simple rule of investing is that it always is better to be a lender than a debtor. There is a reason big banks are big banks. 🙂

  10. Oldie January 30, 2014 at 2:32 am #

    @Brian G: You are right to be strict in your classification — I was thinking rather loosely, and you won’t go wrong by being conservative; I was only trying to consider the other side of the argument. Also, I’m glad you pointed out that bonds, while they may indeed buffer some of the losses of equities in a downturn, and maybe can sometimes even rise in value, as @Neil was advocating, definitely can drop in value too. So characterizing bonds as a “cushion” during a downturn compared to (non-borrowed) cash or repayment of debt seems an overly optimistic position to me.

  11. LifeInsuranceCanada.com January 31, 2014 at 8:36 am #

    >>>>>and others when your emotional brain is telling you only a moron would do such a thing

    Hey, I’m a moron! This is the investment strategy for me!

    I guess I don’t get the emotional upheaval part. I did my research, I know my strategy has been shown to work over the long run and I know that there will be ups and down in the middle. The ups and downs are offset by rebalancing. I don’t get giddy when returns are strong, and I don’t get unhappy when returns fail to perform, because both are irrelevant to long term investments. It shouldn’t be that hard to get rid of your emotions on this stuff.

  12. Andrew February 1, 2014 at 6:29 pm #

    Brian G and Oldie
    Didn’t mean to muddy the waters…its just if we are going to include houses as a financial asset in retirement planning, as financial planners and financial media commonly do, the assertion that paying down a mortgage is a guaranteed return is not necessarily true (i.e. in the case of paying off a depreciating asset) but lenders would like us to believe it so that amortization periods can be extended and house lines of credit encouraged.

    That said I agree with your idea that paying for your house is a good idea before committing most of your funds to investing and your second comment (5:58)is an interesting way to look at it. Some of the potential retirees I know are planning on going into retirement with mortgage debt, with little savings and with the house as THE retirement plan. I just wonder what are the implications of so many people are doing this at the same time as may be the case with baby boomer demographics?

  13. Brian G February 1, 2014 at 6:57 pm #

    @Andrew, I get your point regarding people being too optimistic about their house. I don’t think anyone should depend on the value of their house when retirement planning. We only need to look towards Japan to see what an aging demographic will do to real estate.

    My house is not an investment, it’s a money pit. 🙂 I made no money when I sold my first house… in fact I lost a bit because of real estate agent fees and tax. I am in my second house and it has doubled in value over 15 years… sounds great right? But that’s not counting all the renovations, taxes, utilities, maintenance, etc. that I’ve sunk into it. Then there is inflation. I doubt I’ve made any ROI in real terms, so as an investment it sucks. However, I did get to live here all that time for free… that’s the real value of a house.

  14. Oldie February 2, 2014 at 12:54 am #

    @Brian G and @Andrew: Great sobering review of homes as Not Necessarily A Great Investment (in terms of return), just a nice place to live that may actually cost money! Mind you, so does renting.

  15. aki February 9, 2014 at 8:49 pm #

    I have same question as some of the users, I was looking to invest in index funding keeping my portfolio as 40 20 20 20 ( US index canadian index international index bond).I am 29 and think can take some risk ( In millionaire teacher writer always tells to keep bond ratio as age -10)..I am still new to all this to please excuse me if questions are too stupid)…Is this market is good to invest specially when both TSX and DOW is bull right now.

  16. Canadian Couch Potato February 9, 2014 at 9:08 pm #

    @aki: Your questions are not stupid. But your asset allocation depends on factors other than your age. Many people would find a portfolio of 80% stocks and 20% bonds too volatile. This post may help:
    http://canadiancouchpotato.com/2010/11/10/ready-willing-and-able-to-take-risk/

    While it’s understandable to be nervous about investing during a bull market, trying to time your entry point is not only impossible but completely unnecessary when you are 29 years old and will probably be investing for another 50 years or more.
    http://canadiancouchpotato.com/2013/05/28/ask-the-spud-should-i-buy-in-now/
    http://canadiancouchpotato.com/2013/02/07/scary-when-theyre-down-scary-when-theyre-up/

  17. Bob February 14, 2014 at 10:39 pm #

    I have a question regarding investing in registered V non-registered accounts.

    Those of you who followed my recent posts may recall that I just recently opened a TD Waterhouse account with the intention of buying e-Series funds. After a couple of weeks of waiting and fixing some technical glitches in order to access and fund my account, the TDW account is up and ready and funded with cash that was placed into my RSP. I also opened up a TFSA within this TDW account (I can contribute up to $5500 this year).
    Here’s my question; I intend to buy a mix of funds (CDN, US, Intl and a CDN bond fund) within the RSP. I also intend to contribute monthly and purchase more of the funds on a regular basis. Should I hold them in my TSFA (so a regular contribution that wouldn’t exceed $5500 this year) or hold them as non-registered in the TDW account? What are the tax implications? Would I be better off investing my $5500 in the 3% I am getting at People’s Trust and simply buying more funds outside of the TFSA?

    Thanks!

  18. Tahnya Kristina February 18, 2014 at 11:06 am #

    I think diversification is the key to a good portfolio. Investors have to remember that performance is not an indication of future returns. As a financial planner so many clients ask me how funds performed in the past before they make a decision about purchasing. Ialways advise investors should look at the fund’s objectives and holdings before they look at past returns. If the fund’s objectives are inline with the investor’s goals then it’s a good match.

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