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.
This is great post and maybe quite timely as the markets appear to heading for a correction. I enjoy all your posts Dan but it would be nice to see some information directed towards those of us already retired. Specifically, how do you make withdrawals from one of your model portfolio’s — monthly or annually? Please keep up the great posts; they are very educational.
It’s a very appropriate reminder that a passive investing portfolio does not contain any secret sauce to always generate positive returns. The fact that we enjoyed a multi-year bull run, recently super-charged by a weakening Loonie, is apt to make us forget that.
What I always keep in mind is the fact that, over the last 40 years, the stock market (at least in the US) had negative returns in 1 out of 4 years. So this is bound to happen again, and most likely soon. The Fixed Income portion of a portfolio helps to cushion the blow, but will most likely fail to prevent an overall negative return.
The way I look at it: A long-term investor should know which average annual return she needs to reach her goal. Any intermediary gain above that acts as a cushion to stay on track when the next market pullback needs to be weathered.
Great post Dan
Excellent reminder. My husband and I started investing in 2007 when we got our first jobs out of university. We were both pretty novice investors and I had really just stumbled on a bunch of blogs and books that advocated index investing. I liked what I was reading and it made sense to me.
When we didn’t see much growth in our (admittedly small) account balance in the first year and then the crash in 2008 we weren’t sure we were on the right path. But we stuck with it. Somewhere in my reading there had been an article like this one that reminded me it would not always be a rosy ride and we kept telling ourselves that “stocks are on sale!” to keep us from giving up entirely. Stocks have rebounded quite nicely since then and I’m glad we stuck with it!
Great reminder for all of us out there that haven’t been in the game for that long. I haven’t experienced any significant drops in my portfolio yet but it’s good to reiterate that it WILL happen, and that it’s just part of the long-term game plan.
Very important post and I hear you:
After a bad experience with other active managers a newly retired friend who has a new manager running his actively managed portfolio returned 10.2% this year after a 1.5% manager fee and is now planning a large reno of his house – he will spend all of that 10.2% and a bit more as he is anticipating the same kind of returns in future. He asked me if this was a good return and with his 50% weight to stocks, compared with index portfolios, it was okay, good even. No ETFs only individual blue chip dividend stocks and bonds in this portfolio and major US component. However what he fails to realize is as Dan says above, the last 5 years have been kind of banner and that half his money is in risk assets.
He’s very happy with his manager since he thinks he can now have a reno of his house but isn’t listening to my messages about what is a safe rate of return to assume (and implicitly what is a safe withdrawal rate). He is living in the so called “retirement risk zone” where a few years of bad returns combined with large withdrawals can devastate long term returns. Given his 50% stock weight it is possible (don’t want to speculate if its likely) he will be down 10-15% or maybe more next year and his large withdrawal in 2014 will do him permanent damage. He might have to live on this portfolio for 30 years as he just retired last year.
I also think it is inviting bad outcomes to assume large long run real returns and base lower savings rates on this assumption as my friends seem to be doing (7-8% long run compound total real returns after all fees and taxes)
I assume any money in equity correlated assets could be down 25-40% in any given year and go from there with my plans. How can so many suddenly forget a recent decade of no returns from US stocks? It might also be prudent to assume a safe withdrawal rate of 3% and a similar or even lower expectation of long run real returns from a balanced portfolio.
I am desperately hoping for a pull-back / crash to buy stocks at a cheaper price. After all is that not what investing is all about: buy low – sell high?
Great post – I’ve been thinking how people tend to think much to short term in a number of areas:
-Investing (as noted in the article)
-Sports fans (my team won the last two games – plan the championship parade, or my team lost the last two games – trade everyone and fire the coach)
-Climate change (we’ve had a cold couple of months in my particular corner of the world, so global warming must be bunk)
We all need occasional reminders back up and take a broader longer term view. Thanks for the post.
I’m glad you posted this! I’ve been reading all sorts of the optimistic comments from your readers lately (especially the newbie couch potatoes) and hoped they weren’t expecting to see these types of returns every year! Yes, there will be periods like this (and very often your index portfolio will beat out similarly-weighted actively managed portfolio), but there are certainly going to be bad times ahead.
Stick with it and know that this is a long-term strategy. If you can’t stomach large losses, then your asset allocation needs to be adjusted (i.e., less equity, more bonds) to cushion the fall when times are tough. The key is to keep investing!
Sure, go ahead, pat yourself on the back when you see high returns, but if you’re long-term investor, you should be also be hoping for the market to go down so that you can buy more for less! I sure am hoping for some dips in the next little while…
In light of the current market volatility, a very timely post indeed! A good reminder that the whole point of Couch Potato is to invest in a way that will allow us to quit caring whether the markets are up or down, and to get on with the important and interesting things in life. I’m too old to waste my time worrying about money. Been there; done that.
Over the past year, I have introduced friends to the Potato and have received high praise for doing so. It was easy being a hero in last year’s market. But I never tire of reminding them that markets will go up and markets will go down, and it has nothing to do with me. They should save their thanks for 10 or 20 years from now, when they have received a reasonable long-term return, without the worry. Then they can thank you, Dan.
Hi All:
I wonder, what with the certainty implied in many poster’s comments, and suggested by the Spud, how many of you will now sell and realize your gains and buy back in during the upcoming “correction.”
@Dan: For the record, let me be clear that in no way did I imply that a correction is imminent, only that is a virtual certainty at some point in the future, whether that’s next week or five years from now. And it should go without saying that selling now with the intention of buying back in after a crash is never a prudent strategy. Anyone who who has spent more than 10 minutes on my site would not have inferred that from my post.
Whoa. I have spent more than 10 minutes here.
I appreciate that you share your insights and opinions.
My question is whether anyone here feels so certain that a correction is imminent that they will abandon the strategy and take their gains. IF you could make that sort of forecast with certainty, it would make sense to bail and reinvest at “sale” prices.
I find the term correction interesting in its usage. There is an implication in its very meaning that the current pricing is “incorrect.” If true, would you keep investing? If true, would you sell?
@Dan: Churning assets in order to profit from market up-/downturns is more gambling than investing. This strategy only works in hindsight.
I am following a rebalancing strategy of holding, while incrementally adding to underweight asset classes. Consequently, the only impact of a potential market correction would be to buy more stock, with a focus on the equity sub-classes (CDN, US, EAFE, Emerging) that are most below target.
Awesome and timely article. Great as it follows the recent annual portfolio reports.
It would be great to know more about the withdrawal process post retirement. I know it’s better to withdraw as little as you need when markets are down and not withdraw too much when markets are up, but are there other things to take note of as capital gains/loss optimization might play a bigger factor then?
For most investors, they would do themselves a favour if they just did these things:
1. Make a family budget and stick to it. Make sure you have a savings plan that pays yourself first… that is make a regular scheduled payment into your investment plan.
2. Create an informed investment plan that maps out how you will invest and stick to the plan rather than basing any decisions on day to day noise or emotions.
3. Don’t invest in any stocks unless you have a 10 year time horizon before you need the money.
4. Get on with living and don’t look at your portfolio every day, week or even month. (If you have a good plan, there is no need to either.)
What’s odd, is that if you did this and had *any* low cost, diversified 1 fund portfolio, you’d probably do better than 80% of investors.
@Dan: My apologies, I didn’t mean for my comment to sound harsh. I just wanted to make sure the comments on this post didn’t go down that road. I don’t think anyone is saying they can predict crashes, nor that it’s ever a good idea to time the markets by moving to cash. These ideas are the precise opposite of the Couch Potato strategy.
No worries. Nuance can be hard to convey in text.
The comments by Peter about retirement and Brian G about a 10 year horizon do raise the question of exits and….. Dare I say timing, even if that is not quite market timing.
The markets, unfortunately, do not consider our particular circumstances. Although I am about 13 years from retirement (in all likelihood), I have been considering how to approach those coming years. My investing strategy has always been based upon the statistical result of long term investing – a la couch potato. However, the strategy, as well described by Holger, et al, I see as applicable to my working years, or rather, years in which I can generate a surplus.
Looking down that road to the point at which I must make decisions about securing, converting, or whatever, gives me pause about how to make such decisions. Thirteen years will hopefully give me time to analyze how best to make that decision.
Market volatility at the point when is little time or ability to recover is concerning.
@Dan: If your investment horizon shrinks then you are right that you need to decrease the risk exposure of your portfolio. The problem is that this decreases the expected returns as well.
What I would do in your situation is calculating expected returns and worst case outcomes for a set of different portfolio mixes (shifting percentages between equity, fixed income and REITs). Choose whatever gets you to your target without too much risk (whatever “too much” is for you).
another great post. thanks ccp!
@Dan, I am partially retired and this is how I judge the maximum of how much I can invest in stocks… I ask myself how much of my investments do I not need for 10 years?That’s the maximum that I can invest in stocks.
Then I ask how much do I need this year? That’s in cash.
Then I ask how much do I need in 1-5 years? That’s in GIC’s or short term bonds.
The rest goes into normal bonds.
I redo these calculations every year and rebalance.
But this just the way I see it…
Brian G’s approach to asset allocation is quite interesting.. anyone see any deficiency here?
@Be,en – Brian points out that he is partially retired and this may work in his situation. However, I am decades from retirement, and this would indicate that I could have 100% of my portfolio in stocks. This is too high for my preference – I have about 30-35% in bonds.
Hey guys you missed a word. With my first rule I did say that is the *maximum* that I would invest in stocks. If I was younger I personally wouldn’t go above 60% even if I could.
I am wondering now if I should wait a few more weeks to see how this recent drop in he markets is the beginning of a “trend” toward a bear market… or, should I just jump in and by those e-Series I’ve been eying? I’ve read countless times that you cannot time the markets, but it seems that it’s been long 5-year run of good to great returns… something has to give you’d think. Quite a few people seem to think that the good times will change soon. WOuld it hurt to wait a few more weeks/months? I’m intending to stay in this for the long run…
@Bob: If you’re sitting on a big pile of cash and you don’t want to invest it all at once (in case prices drop in the future), you should really look at a Dollar Cost Averaging or a Dollar Value Averaging strategy. By gradually investing over a period of time, you’re “protecting” yourself against market downturns and upturns. (Note: Making monthly purchases will only be cost-efficient for mutual funds, commission-free ETFs, or ETFs that support Pre-Authorized Cash Contribution.)
@Bob: “Prediction is very difficult, especially about the future” (Niels Bohr, later paraphrased by Yogi Berra). Numerous objective mathematical analyses of the results of timing the market show no benefit, whether in safety or profit.
The mathematics of an average is so easy to grasp, that we think that smart people must know something more complicated and better. Hence the huge emotional appeal of sophisticated formulaic determinations of market timing schemes and other methods that have failed to demonstrate economic in true objective practice.
Dull, boring, average and non-intuitive, index investing is not spectacular, but it’s highly predictable to match the mean.
@ Dan, I’m looking at a small initial invest of about $7000 to $8000 (which represents about 5% of my cash) then contributing monthly to the funds. Dollar cost averaging is the strategy we want to employ. I did read about it in both Hallan’s and Malkeil’s book… makes sense. We’re likely not going to wait much longer. I want to start this up before the RSP deadline as I will be purchasing the initial investment through the RSP then contribute with TFSA allotment throughout the year, if that makes sense. We want to shelter these investments as much as possible while trying to get some tax refund. My wife and I have a lot of RSP space.. thanks
@Bob: You could do worse than continuously adding to your investments over the next months. A few thoughts and suggestions:
First, maximising your RSP contribution before the upcoming deadline makes sense. Then you get your refund still in 2014. Second, consider holding the cash in a HISA with one of the Manitoban credit unions. You’ll get annual interest of 1.8% or more that way. Third, remember that monthly contributions add a slight drag to your profit through increased transaction fees. For example, investing $150k in 5% portions with a $9.95 transaction fee would increase initial expenses by 0.13% (19*9.95/150,000) compared to a lump sum investment.
Hey Holger, thanks for the input…
On your 1st point; agreed about the RSP, although with our DB pension, I’ve read that maximizing RSPs might mean higher taxes in retirement (still 25 years away!). I won’t max out my RSP b/c we need the cash in about 3 years to buy a house (we rent now).. I won’t qualify for HBP (the Mrs will.. so she’ll max out)
On your 2nd point; We’ve stashed cad into Peoples Trust… TFSA @ 3% and I think we’ll take advantage of their RSP at 2.35 % over 3 years. The HISA is also 1.8% at Peoples
On your 3rd point; I thought the TD e-Series doesn’t cost anything extra to contribute monthly (this is what we are going to go with… unless I change me mind and go with INGs Streetwise)
@CCP: How long does it take ETF fund managers to compute the price of the shares? Or rather, how long does it take the instantaneous mean worth of, say the constituent shares underlying the MSCI World Index to get computed into the index, and then for the index to get incorporated into the price of my ETF that is supposed to be tracking that index? Is the lag time in the order of weeks, days, hours or seconds?
@Bob: If dollar cost averaging gives you peace of mind, by all means go for it. However, you should be aware that investing all at once (minus the cash you need for emergencies and the home down payment in 3 years) regardless of what the gurus are forecasting is usually the highest-return decision: https://canadiancouchpotato.com/2013/05/31/does-dollar-cost-averaging-work/
Also, keep in mind that the market forecasters are wrong more often than they’re right :)
@Oldie: The intraday NAVs are calculated every few seconds. In international markets, where time zone differences mean markets are open at different times, there can be some short-lived anomalies, but these should not be a concern to anyone buy day traders.
https://canadiancouchpotato.com/2013/03/18/the-etfs-price-is-right-except-when-its-not/
I have a comment regarding the annual rebalancing of indexes (i.e. securities included or excluded from an index). They act as a drag to index funds, since they are typically included (bought) in the fund when at higher value and excluded (sold) at lower value. Research estimates this drag at 0.2%-0.7%. With the fund’s MER, the total drag can amount to 1% in some cases.
(http://www.petajisto.net/papers/petajisto%202011%20jef%20-%20hidden%20cost%20for%20index%20funds.pdf)
I understand this is a small drag compared to MER of managed funds. Still, it appears to me that an investor able to build a well diversified portfolio by directly buying some of the underlying securities of the index funds (maybe by choosing them at random, to stay in a Couch Potato spirit) with annual commission costs lower than, say, 0.5% of his investments would be better off. Do you agree?
“There will be periods when indexing feels like…your emotional brain is telling you only a moron would do such a thing. ” <– And those moments are when I'm going to rush back here, read and reinforce as much as I can, and watch Bogle videos like a madman.
I wonder now at some of the potato newbies who only few weeks ago, when everything looked rosy forever, proclaimed things like they were going to do the strategy, but felt like it was a good idea rejig it so that they were going in 100% equity. People said, "Don't do that!," but I wonder if they listened. Recency bias can be a difficult mistress to kick out of the brain's bed.
@ Neil, this is closer to my position:
“I disagree, DCA is also a strategy for investing over the long term for an individual investor who does not have $200k sitting around or receive an unexpected windfall.”
“The question an average person is more likely to face is, do they invest $200 a month or do they wait until 12 months have passed and invest $2400? I believe the math will be reversed in those cases and DCA is very advantageous both from getting invested first and from minimizing downside risk.”
that $8000 is the max I am comfy with investing… I ain’t going to put $100k into this – money I need for a house purchase… Wife will divorce me!
Investing in a portfolio is like buying gas for your car. Sometimes you buy low, sometimes you buy high, but on average the price keeps going up over the long run. If people only had the same emotional detachment for their portfolio they have for buying gasoline for their car… :)
@Bob: If you are allotting $200 a month to be available for investing on an ongoing basis, then, assuming you are purchasing TD mutual funds which cost you nothing per purchase transaction, then it should be a no-brainer — you should purchase the funds in the ratio you have predetermined monthly immediately when the cash is available.
If you have a larger lump sum now that you want to put in to start the portfolio rolling, I understand your fear that you don’t want to waste your money buying at a price which later in retrospect may be regarded as too high a price. But remember you have no clairvoyance, and therefore no real way of knowing if this will be so, despite what the so-called market experts may be proclaiming. Remember, you have an equally plausible chance that the price at which you purchase may in retrospect be seen as a huge bargain. The two opposing and unquantifiable risks balance each other out, in my view, and you would be rationally sound to purchase all your initial instruments immediately, now that you have the cash.
If the emotional impact of buying “at a loss” overwhelms the equally likely possibility of “buying at a bargain”, then by all means spread your purchases out into equal dollar quantities made regularly over the course of a year, say, to achieve your dollar cost averaging. But put the cash in now before the February deadline so you can qualify for the RRSP contribution tax deduction now, and put the money within the RRSP into an interest bearing account until the amounts are used up in you planned regular purchases. And remember, all other things being equal, you are losing the opportunity cost of 6 months (the average of the time that your lump sum stays in the interest bearing account) times the difference between the average long term return in equities and the interest your cash account is generating.
@Oldie
You’re quite right, none of us have the power of clairvoyance, so it’s impossible to know when it’s the best time to buy or sell. This post came out just at the right time for me, because I just made a 5 figures, lump sum purchase in the beginning of last week, right before the slide on Thursday and Friday. Over the weekend, I was beating myself up for not waiting a few more days, which could have save me a few thousands dollars.
I had to read a few of CCP’s articles, other blog posts, as well as videos at Sensibleinvesting to realize that it’s just a fact of life. I’m investing for a minimum of 10 to 15 years, so daily fluctuations should have no bearing on my portfolio. It’s a marathon, not a 100m sprint.
This has been a most helpful thread. Thanks folks, for all the sound advice.
Cheers..
@LK: I really think this is red herring. Most of the core index funds in my model portfolios are total-market funds, which means there is an extremely small amount of turnover: certainly much more than the S&P 500 or the Russell 2000, which are rather notorious in that respect:
https://canadiancouchpotato.com/2010/02/10/the-sp-500-effect/
It would be impossible to get the same diversification as an index fund by just picking a few random stocks in the index, and your transactions costs (including commissions and a bid-ask spreads) are almost certain to be greater than 0.5%.
@David L: Good comment. Myself, I also am a new enough index investor that so far I can’t help myself checking prices the next few days or so after I buy — and on the occasion when it appears that I bought on a peak that dropped later, I still get a twinge (or more) of regret. You’re not alone. Yeah, I know, I talk a good talk, but all the rationalization and intellectualization in the world (it’s a fact of life, etc.) still hasn’t replaced that old instinctive human regret of “I wish I had…” for me yet. It’s good to be comforted and reminded by your last 2 sentences, especially “It’s a marathon, not a 100m sprint!”
Now I only hope that my equanimity improves to the point that I even learn how not to look at prices after the fact within the next few days or weeks, or at least until there’s a reasonable possibility that it may be time to rebalance again! At least, that’s the standard I would set to consider myself a “seasoned index investor”.
@CCP: If, as you say, the total (or close to total) market funds recommended in the “Recommended ETFs” page of this website are free from the effect that @LK is concerned about, would that relative immunity apply essentially as well to XIU (largest 60 companies on TSX) and VCE (79 largest companies)?
@CCP
Thanks, that makes a lot of sense. Using total market products does solve that problem.
I’m just about to make the jump and start following one of the couch potato model portfolios. Most of the funds recommend investing 40% to Canadian bonds, which have been fairly low yielding, even since inception. I am paying 3.84% on my mortgage currently. Any reason not to invest the 40% in paying down my mortgage instead? My account does not penalize me for over-payment.
@Chris: Holding VAB currently yields 3.23% before tax (i.e. much less after tax), plus carries some interest rate risk. Paying down the mortgage gives you a 100% guaranteed 3.84% return (by not having to pay the interest). Sounds like a no-brainer to me.
Do you think the Global Couch Potato strategy is something you could use your entire life? From the beginning until you retire? Or at some point would it be prudent to branch out? I’m happy to stick it out and have for about 7 years now so know the ups and downs are inevitable….just wondering if I should think about doing something else down the road? Thanks!
@Chris: In my opinion, the primary purpose of the bond allocation is to zig when the rest of the portfolio zags, not for its returns on its own. For example, TDB909 returned 5.65% in 2008 when everything else took a 30%-ish dive. This accomplishes two important things: it reduces your volatility during scary times, which helps fight the instinct to sell, and it allows you to re-balance to buy more when equities are low. You lose both of those effects if you take the 40% and put it into the mortgage.
That said, paying some of your mortgage instead of investing could be a good decision. I just don’t think it should come exclusively from the bond allocation. Maybe 40% is too much if your horizon is long, but bonds have a role even in our low-yield environment.
@Chris – I concur with Neil. While it may make sense to use funds in a non-registered account to pay down the mortgage for the guaranteed return, I would then allocate a percentage of my remaining portfolio to bonds for the reasons Neil describes. Depending on your risk tolerance and time horizon, this is your choice.
@Neil: This may be a philosophical question rather than one with a definite answer, but as a new index investor, I wondered about the validity of the first of your two losses-of-effect in your first paragraph, last sentence. That is, if you put the money in the mortgage, does this not also also add to the effect of “reduces your volatility during scary times”? To look at my question from another perspective, if you put X cash into the bond portion of your portfolio, what really is the meaning of the nominal X dollars “cash/income” buffering your potential equity losses when the X value is offset by the -X of your ongoing mortgage debt?
Another aspect of this topic would be that, if the beneficial effect of having net cash funnelled into the investment portfolio rather than to paying down the mortgage is truly there, then perhaps one should pay down the mortgage, then take out a new loan backed by the house equity to use as the cash/income of your portfolio. This may seem aggressive and risky at first glance, but it is really equivalent to the cash directly-into-investment-portfolio scenario, and at least in this second scenario the loan interest for the purpose of investing is tax deductible.