In recent years, the so-called Yale Model has been extremely popular with investors. The model is an attempt to mimic the investment strategy used by Ivy League endowment funds, which have an outstanding track record of beating the market indexes. David Swensen, the superstar manager of the Yale endowment fund, delivered returns of 10.1% annually from 2002 to 2011, a decade when stocks returned 3.9%. The Harvard endowment returned 9.4% over the same period and has grown 12.9% over the last 20 years.

The Ivy Portfolio, by Mebane Faber and Eric Richardson, describes how Yale and Harvard use an asset allocation model that is broadly similar the Couch Potato strategy. The key difference, however, is that the endowments include a number of asset classes that are not available to retail investors, including private equity, hedge funds, and direct ownership of timber resources and commercial real estate.

The first half of Faber and Richardson’s book is a fascinating look at how individual investors can mimic the Yale Model. The authors quote both Swensen and Jack Meyer (Harvard’s former endowment fund manager), both of whom recommend building diversified portfolios with low-cost index funds. Then they offer three possible “Ivy Portfolios” that anyone can assemble with ETFs: the simplest one allocates 20% each to US stocks, foreign stocks, government bonds, real estate and commodities. Two other chapters explain that private equity and hedge funds can be profitable for institutional investors, but are best ignored by the great unwashed.

It’s all in the timing

So far, so good—but the latter half of The Ivy Portfolio goes a giant step further. Rather than simply encouraging investors to diversify widely and rebalance, Faber explains his strategy for protecting oneself from dramatic drawdowns, or “winning by not losing.” He points out that four of the five asset classes in the Ivy Portfolio have experienced declines of about 50% or more since 1973. (Government bonds were the only exception.) “So, is there a way to avoid these long bear markets and losses?” he asks.

The suggestion Faber offers in the book is based on his paper A Quantitative Approach to Tactical Asset Allocation, first published in 2007 and updated in 2009. It’s still the most downloaded paper on the Social Sciences Research Network, which testifies to its extraordinary popularity.

Faber’s strategy is actually very simple. You just check the price of each asset class on the last day of each month, and if it is greater than its 10-month simple moving average (SMA), you buy (or continue to hold). If the price is less than the 10-month SMA, you sell and move to cash. In other words, it’s straightforward market timing.

If one had employed this timing strategy with U.S. stocks from 1900 through 2008, Faber reports, it would have delivered returns of 10.45%, compared with 9.21% for the S&P 500. More remarkable, it would have protected you from almost all the worst drawdowns: it even earned slightly positive returns in 1931 and 2008, when the market lost 44% and 37%, respectively. Faber’s analysis shows similar results when applied to international stocks, real estate, commodities and even 10-year government bonds. In all cases, the timing strategy produced higher returns with much lower volatility, while avoiding the largest drawdowns.

Backtested from 1973 through 2008, the the Ivy Portfolio with the market timing strategy trounced a buy-and-hold approach and delivered returns that would have made Swensen and Meyer smile:

These are very impressive results, especially when you consider that they came about with an average of just three to four round-trip trades per year.

The Ivy Portfolio is an excellent book that I would highly recommend to index investors (though I would discourage them from building a portfolio that is 40% real estate and commodities). But how about Faber’s timing strategy? Is it a recipe for lowering the volatility and improving the long-term returns on a Couch Potato portfolio? I’ll consider that question later this week.

If you’ve researched the theoretical foundations of index investing, you’ve no doubt come across Modern Portfolio Theory and the Efficient Markets Hypothesis. And if you read the commentaries of active money managers and the financial media, you’ve probably seen countless articles that dismiss both as obsolete. Modern Portfolio Theory is declared dead after every market crash, and all stock pickers, almost by definition, believe markets are not really efficient. Many of these critics think passive investing is folly—only the warm embrace of active management can protect you and your portfolio.

In his provocative book, Risk, Financial Markets & You, the Winnipeg-based financial advisor Alan Fustey adds his own criticisms of these two decades-old models. But his conclusion is surprising. When I interviewed him recently, I asked what investors should do if these models were broken. “Well, the first thing you do,” Fustey replied, “is you index.”

The background

Before going further, let’s review these two landmark financial theories, both of which revolutionized investing. Modern portfolio theory was devised in 1952 by Harry Markowitz, who later shared a Nobel Prize for his contribution. Markowitz showed that by combining risky assets that have less than perfect correlation, you can create a portfolio that has lower risk and a higher expected return than its individual components. Index investors understand this as the “free lunch” offered by diversification.

The efficient markets hypothesis was formulated by Eugene Fama in a 1970 paper. It suggests that security prices reflect all public information, and therefore analysis of individual companies does not allow investors to identify “mispriced” stocks. (Occasional mispricings probably exist, but they cannot be reliably exploited.) In an efficient market, buying an index fund is the best way to get market exposure at the lowest possible cost.

‘You’ve got to have a better alternative’

These two ideas are among the pillars of the Couch Potato strategy. But as Fustey explains in Chapter 4 of his book, both have some shortcomings. For example, he says, MPT presumes that asset class correlations remain constant, and that market returns follow a normal distribution (represented by a bell curve). We know neither of these assumptions is valid. He also points out that it is possible for some  participants to have an informational advantage, so capital markets are not truly efficient.

But if you think Fustey is building a case against passive investing, think again: he argues that indexing still offers investors their best chance of success. “It comes down to this,” he told me. “If you’re going to throw out these ideas, then you’ve got to have a better alternative. If you reject the efficient markets hypothesis, you’re saying that you have the ability to get superior information, and that you can make money from that knowledge. But that flies in the face of reality. Someone is always going to have better information than someone else, but are you going to be able to profit from that on an after-fee basis? I don’t think so—and the history of active management proves that.”

Book giveaway

Alan Fustey is a CFA and a portfolio manager at Index Wealth Management, a Winnipeg firm that also has offices in Calgary and Vancouver. I recently added the firm’s three offices to my Find an Advisor directory.

Alan sent along two copies Risk, Financial Markets & You to offer to readers who are interested in learning more. Leave a comment below to be entered in the draw for the books. Contest closes at midnight EST on Wednesday, May 2. I will announce the winners in Thursday’s post.

Speaking of contests, a big thanks to everyone who requested a ticket to PWL Capital’s event featuring Carl Richards, author of The Behaviour Gap. The answer to the skill testing question was Buckingham Asset Management (BAM Advisor Services was also acceptable). Winners will be notified by email.

I once went to an investment seminar at my local library. It was attended by a handful of folks who had little or no experience with investing and were looking for someone to put them on the right track. The guy leading the session held up a copy of the Globe and Mail business section and encouraged us all to read it every day so we could learn what was happening in the economy and apply it to our investments.

That is some of the worst financial advice I’ve ever heard, and if Carl Richards had been there I imagine he would have thrown a few rotten eggs and tomatoes. Richards’ new book, The Behaviour Gap: Simple Ways to Stop Doing Dumb Things With Your Money, spends most of its 178 pages encouraging investors to ignore the headlines and focus on the real determinant of financial success or failure: ourselves.

“Forget about what’s going on in China or global demand for the dollar or the price of gold,” Richards writes. “While we’re worrying about those things, we could be doing things that actually make a difference in our financial lives—like working or trying to figure out how to save or earn a little more.”

Richards is a financial planner and a New York Times blogger who has a remarkable talent for distilling his insights into napkin sketches. His book sets out to discover why Dalbar studies demonstrate that equity investors have underperformed the market by over 4% annually over the last 20 years. The primary reason isn’t high fees:  if that’s all it were, the difference would be much smaller. Rather, it’s a behavior gap: Richards’ term for the difference between what investors should do and what they actually do.

Stop smoking, start saving

One of the anecdotes Richards shares comes from a former doctor who changed careers to become a financial adviser. The adviser regularly hears from clients who are desperately seeking higher returns while ignoring far more important parts of their financial lives, which reminds him of a former patient. This patient loved to debate about which medication was the best treatment for his high blood pressure—but he refused to stop smoking.

I encourage investors to remember this story the next time they want to make adjustments to their portfolios Even the Global Couch Potato is more than adequate to help you reach your financial goals if you’re a disciplined investor. I would estimate that will outperform 90% of individuals (on a risk-adjusted basis) over any period longer than 10 years. It’s not perfect, and you might be able squeeze out as much as a percentage point with more diversification or cheaper products. But chances are your behavior has a bigger influence on your returns than the specific funds in your portfolio.

For example, if you’re not saving enough, or if you’re carrying credit card debt, it makes no sense to worry about giving your investment returns a boost. Your precise allocation to US stocks, Vanguard versus iShares, or whether you use currency hedging—all of that is meaningless by comparison. Saving more and paying down debt will always swamp these decisions.

See Carl Richards live

If you’d like to hear more of Richards’ insights on the behavior gap, here’s your chance. PWL Capital Inc. is bringing Richards to Canada for a series of presentations in Toronto, Ottawa and Montreal. I have accepted an initiation to attend the Toronto event, and PWL is offering a limited number of invitations to Canadian Couch Potato readers in each of the three cities.

The Toronto presentation will take place on Tuesday, May 22, at 6 pm. The Ottawa and Montreal events will be held on Wednesday May 23 at 11:45 am and 6 pm, respectively.

If you would like to be entered into the draw for free tickets, email me with the answer to the following skill-testing question: What is the name of the firm that employs Richards as its director of investor education?

Please include your full name and indicate which of three events you would like to attend. Entries must be received by midnight on Sunday, April 29. I’ll announce the winners in next Monday’s post.

Larry Swedroe’s new book, Investment Mistakes Even Smart Investors Make and How to Avoid Them, includes 77 common behavioural blunders. I don’t think there’s anyone alive who hasn’t made at least a dozen of them. In fact, I know two investors who recently fell prey to Mistake 11—and one of them was me.

Mistake 11 in Swedroe’s catalogue goes like this: “Do You Let the Price Paid Affect Your Decision to Continue to Hold an Asset?” This error is what behavioural economists call the endowment effect. It’s what makes us place a greater value on something just because we happen to own it.

Imagine that you want to attend a hockey game. You don’t yet have a ticket, and you decide that you’re willing to pay no more than $100 for one. The next day, you win a ticket to the game in a radio contest. If a friend offers to buy that ticket from you, for what price would you be willing to sell?

If you were purely rational, you would accept any price over $100, since that’s the maximum value you placed on the ticket before you had one. But if you’re subject to the endowment effect, the ticket is likely to be worth much more to you now that you’ve got one. In one famous experiment, subjects said they were willing to pay a median of $150 to buy a ticket, but their median selling price was $1,500. Somehow simply owning the ticket increased its value tenfold.

Too cheap to sell, too expensive to buy

I recently spoke to an investor I’ll call Stephanie, who provided a perfect real-life example of this odd behaviour. Her advisor had purchased a small-cap energy company in her portfolio, and the stock had since lost over half its value. She wasn’t just bothered about the loss—she was angry that the advisor had purchased the stock in the first place, since she wasn’t interested in speculating on junior resource companies.

“Why don’t you sell the shares and buy something more suitable?” I suggested.

“I think the stock might come back a bit,” Stephanie replied. “I’ll give it another six months or so.”

I thought about that for a second. “If you didn’t own this stock already, would you buy shares today?”

“Of course not,” she said. “Why would I do that? I just told you that risky stocks like this aren’t  part of my strategy.”

You can probably spot the irrational thought process here. If she thought the stock was incompatible with her investing strategy, then she should have been prepared to sell all of her shares immediately. The fact that she already owned shares in the company should not have had any bearing on the decision. Indeed, if she truly thought the stock was going to go up in the next six months, why not buy more shares?

To avoid falling prey to the endowment effect, Swedroe suggests asking yourself: “If I didn’t already own the asset, how much would I buy today as part of my overall investment plan?” If your answer is “none” or “less than I currently own,” then you should sell the asset now and replace it with something that suits your long-term strategy. (One caveat, which Swedroe acknowledges: the decision to dump an inappropriate investment is not so simple if you’d face a large tax hit on the capital gains.)

Another real example

I can’t be smug about Stephanie making Mistake 11—I admit I’ve fallen prey to this cognitive error myself. When I set up my Complete Couch Potato RRSP in early 2009, I used the iShares S&P/TSX Capped REIT (XRE), since it was the only option for real estate at the time. The following year, the BMO Equal Weight REITs (ZRE) was launched, and it uses an equal-weight strategy that I believe is preferable for sector funds that include a small number of companies. That’s why I recommend ZRE it in my Model Portfolios.

If I was building my portfolio from scratch today, I would certainly use ZRE. But I confess I haven’t switched yet. It might have something to do with the fact that my position in XRE is up more than 84% based on my average price, which is pretty satisfying. But as Swedroe reminds us, the price I paid in the past is not relevant: it is far more important to hold the asset that is best suited to my long-term strategy going forward.

So next time I add money to my RRSP, I’m going replace XRE. In the future, I hope I’ll be less likely to fall victim to the endowment effect. Now it’s time to start working on the other 76 mistakes.

Readers often ask me whether the Couch Potato strategy is suitable for investors  approaching retirement, or even those who have stopped working. In his recent book, Retirement’s Harsh New Realities, Gordon Pape addresses the same question—and I strongly disagree with his advice.

Pape acknowledges that the Couch Potato strategy is simple and low-cost, but “the real questions are how safe the investment is and how much you will end up earning on your money by adopting a passive strategy,” he writes. “I think the couch potato approach fails on both counts, for two reasons: time horizon and human nature.”

Fatal flaws?

“Passive investing requires taking a long-term view, ten years or more,” Pape argues, but “many people, especially those over fifty, aren’t comfortable with the idea of waiting many years for a decent return. They need to see profits sooner.”

Second, he argues, it’s not realistic to expect people to adhere to a passive strategy because markets are too volatile. He offers the massive losses of 2008 as an example: “How many couch potato investors would have had the fortitude to stick with the plan through that debacle?”

Pape goes on to explain how he set up a model Couch Potato portfolio in January 2008 and tracked it to the end of April 2011. During this 40-month period, the portfolio delivered an annualized return of just 1.06%. “Most people would not be happy with that, and with good reason.”

His final verdict: “While it’s true that you might do worse by actively managing your money, at least you, and not the markets, are in control of your financial fate.”

Blurring two ideas

Pape’s book, like his previous work, includes a wealth of excellent advice for Canadians who are nearing retirement, but he badly misrepresents passive investing.

To begin with, Pape is wrong to declare that a passive strategy requires at least 10 years. It’s equity investing that needs a long horizon: active or passive management has nothing to do with it. An investor with a shorter time frame can simply adjust the allocation of a passive portfolio to suit her goals. A 65-year-old who is retired, or a parent saving for a teenager’s education, might keep 80% of the portfolio in a short-term bond ETF and only 20% (or less) in equities. Passive investing is suitable for any time horizon.

Pape writes that “the performance of the portfolio during the 2008 market crash shows that this approach is not risk-free or even low-risk.” I’d love to know who ever claimed that it was. Why should anyone expect indexing to be less risky than active management? Risk exposure is determined by asset allocation, not by management style.

Perhaps Pape was referring to the idea that active managers can change the asset mix during times of crisis to protect against big losses. However, the evidence suggests that they cannot do this reliably, and that over market cycles active management usually underperforms a strategy of buy, hold and rebalance.

Lamenting his model portfolio’s 1% annualized return from 2008 to mid-2011, Pape says: “This is the reality of couch potato investing—timing counts for a lot. If you set up a portfolio a few months before a market plunge, it will take years to recover.” Once again, this is the reality of equity investing, and active-versus-passive is completely irrelevant. Everyone knows that stocks can lose money over periods of 40 months—which is why his model portfolio of 60% stocks is not suitable for that time horizon. If you don’t have several years to recover from a severe market decline, then you shouldn’t invest in stocks, period.

The illusion of control

Pape argues that investors over 50 should not use a passive strategy because they “need to see profits sooner.” He later argues that with an active strategy “you, and not the markets, are in control of your financial fate.” Really?

Saying that older investors “need profits sooner” is like saying farmers need rain next week: it might be true, but there’s nothing they can do about it. As Alexander Green explains in The Gone Fishin’ Portfolio, six factors affect a portfolio’s performance: how much you save, how long your investments compound, your asset allocation, how much you pay in expenses, how much you lose to taxes, and the return on your investments. We can control the first five—and only two (costs and taxes) are closely linked to the active-versus-passive question. No one can control the return they get on their investments, whether they admit it or not.

Whether you’re 20 or 97, the markets give what they give. If you need market-beating returns to reach your goals, then you either need to take more risk (which opens you up to larger losses), or you need to lower your expectations and save more money. Building a retirement strategy without understanding this is downright dangerous.

Passive investing is not for everyone, but the choice to become a Couch Potato has nothing to do with your age, or how close you are to retirement. Make sure your investing decisions are based on facts, not myths and misinformation.

It’s hard not to respect Andrew Hallam. I first learned about him in the pages of MoneySense, where he described how his investment club (made up of fellow teachers) had beaten the S&P 500 year after year. Hallam eventually amassed a portfolio worth more than a million bucks on a decidedly modest salary.

But that’s not why I respect him. Most people in his shoes would have written a book with a title like, How to Get Stinking Rich Now! Secrets From a Stock-Picking Savant. Not Hallam. Instead, he set about encouraging people to live frugally, save money, and invest in index funds, often buying boxes of John Bogle’s books and handing them out to his colleagues.

Now he’s written his own book with a similar message. Millionaire Teacher presents Hallam’s nine rules of financial success. Rule 1 is the one most investment books ignore: your personal savings rate—not your investment choices—is the most important factor in determining your wealth. The road to riches, he explains, is usually mundane: live within your means, avoid the pitfalls of easy credit and overconsumption, invest your surplus and the rest will look after itself.

In this respect, the book strikes a perfect balance when compared with other popular titles. David Bach’s The Automatic Millionaire trivializes wealth building by making it sound like something you can do by simply cutting out your $5 morning latte. At the other end of the spectrum is Thomas Stanley and William Danko’s The Millionaire Next Door, which profiles a lot of rich people that strike me us humourless, sanctimonious and selfish. Hallam doesn’t gloss over the sacrifices you need to make, but he’s no miser, either: his generosity, wit and contentment with life pervade the writing.

Lessons learned

Rule 4 tackles the behavioural mistakes we all make as investors: we’re overconfident, we don’t learn from history, and we make portfolio decisions based on emotion. (You can read an excerpt of this chapter in MoneySense.) One of the reasons Hallam has been so successful is that he’s followed Warren Buffett’s famous advice about being greedy when others are fearful: he bravely rebalanced his portfolio by selling bonds and buying stocks after 9/11, and again 2008. His example should give other investors the confidence to do the same.

In subsequent chapters, Hallam describes the process of building a portfolio of index funds or ETFs (using real investors as case studies) and lays bare the techniques that financial advisors use to sell their services. I wasn’t surprised to read his story about visiting a Canadian bank with his mother to try to buy index funds. After the saleswoman realized Hallam knew far more about investing than she did, she admitted that the bank instructed her never to mention index funds to potential clients. For approximately 7,894 similar stories, see this post.

For those who can’t resist

The final rule in the book is called “The 10% Stock-Picking Solution…If You Really Can’t Help Yourself.” Here Hallam explains that most investors simply cannot resist stock picking, and he goes on to describe many of the techniques he used during his decade of superstardom.

My first reaction was that this chapter undermined the message of the previous eight, and I wrote to Hallam to say so. Here’s how he replied:

“From my experience, few men can avoid stock picking. How many of the people reading our blogs have fully indexed accounts? I would wager that only a small percentage do. It’s an inherent (especially male) quality to develop the urge to buy a few stocks. Knowing that, I wanted to set a few guidelines to follow, while suggesting that stock pickers, even following my strategy, will very likely lose to the indexes when doing it.”

It’s that kind of experience and wisdom that makes Millionaire Teacher such an outstanding book. It’s easy to find excellent books about investing, but it’s rare to read an author who so clearly understands how people think and act in their financial lives. This one is going on my list of recommend reads.

Canadian Couch Potato is pleased to announce the birth of The MoneySense Guide to the Perfect Portfolio. My new book has just hit the shelves across Canada: look for it on the magazine stand at Shoppers Drug Mart, Walmart, Chapters/Indigo and Loblaws stores, or buy it online. At just $9.95, it’s the same price as a single ETF trading commission.

The MoneySense Guide to the Perfect Portfolio is a roadmap for the do-it-yourself investor in Canada. It begins with my best attempt at laying out the case for passive investing: I explain the problems with mutual funds and active stock-picking strategies designed to beat the market, and I encourage investors to focus on the things they can control rather than basing their financial lives around the pursuit of an unlikely goal.

The next two chapters explain the importance of saving, setting targets and making a financial plan. This is an often neglected part of the investing process: it makes no sense to dwell on individual securities or funds unless you have some context for your investments. I look at the importance of gauging your risk profile and explain how you can build a portfolio that is suited to your goals.

Chapter 5 is a complete guide to choosing the most appropriate index funds or ETFs for your portfolio, while the next two give step-by-step instructions on opening a discount brokerage account and placing mutual fund and ETF orders. Many experienced investors take this stuff for granted, but it’s intimating for novices, and it’s one of the main obstacles preventing people from becoming DIY investors. I want to thank Ram from Canadian Capitalist, Michael James, and Mike from MoneySmarts for reviewing this material and offering suggestions.

The next two chapters deal with rebalancing (download my rebalancing spreadsheet to help you) and staying the course. As many index investors know, it can be difficult to stick to your plan when markets go south, so I offer some suggestions for tuning out the noise.

To put a human face on all of this, we’ve included five stories from real investors. One is Andrew Hallam, author of Millionaire Teacher, who explains why he gave up stock-picking even after a decade of tremendous success. We also hear from several other MoneySense and Canadian Couch Potato readers: my thanks to all of them for sharing their experiences as DIY index investors.

Portfolio performance data is here at last

The final chapter of the book includes my Model Portfolios, and that leads to my next announcement. With the help of Justin Bender of PWL Capital in Toronto, I am now publishing monthly performance data for the Model Portfolios and their underlying ETFs. I’ll upload a new PDF report each month (there’s a permanent link on the Model Portfolios page) as soon as the data are available. A few important notes:

• The portfolio returns only go back to the beginning of 2011. Many of the ETFs I recommend are new, and I did not want to simulate performance using index data. It would have been nice to provide backtested three-year numbers—stock markets are up 30% to 50% since then—but that would have been dishonest. (Actual 10-year performance numbers for the Global Couch Potato using TD e-Series funds are available here.)

• All returns are expressed in Canadian dollars. Readers should find this extremely useful, as all of the publicly available performance data for the Vanguard ETFs I recommend are in US dollars.

• These are total returns, which means they include dividends and interest. This makes them far more useful than tools like Google Finance, which only graph price changes and ignore distributions.

• Trading commissions and taxes (including withholding taxes) are ignored, since they will be different for every investor.

PWL Capital has also provided a link to its own monthly market statistics, which include index data that may help you benchmark your own portfolio. Click the banner in the right-hand sidebar to access the most recent report.

Hope you’ll pick up a copy of the book, and that you’ll track your Couch Potato portfolio’s performance here on the site.

Dan Solin’s excellent new book, The Smartest Portfolio You’ll Ever Own (see my review here) devotes several chapters to whether passive investors should work with an advisor. It’s a question I’ve considered before, and I think Solin has a lot of interesting insights to share.

The suggestion that most investors should use an advisor is a tough sell in the financial blogging community. Most Canadians with significant assets work with advisors, but the proportion of DIY investors is surely much higher among regular visitors to websites like this one. Indeed, many Couch Potatoes embraced the strategy after a negative experience with an advisor, and that aftertaste will take a long time to fade.

As a DIY investor myself, I’m happy to support people who manage their own portfolio. At the same time, I believe that most investors are likely to do better over the long run if they work with an advisor—as long as it is the right kind of advisor. Unfortunately, there are huge problems with the advice industry in Canada, which is dominated commissioned salespeople who charge hidden fees embedded in financial products, and who believe that an advisor’s role is to select winning fund managers or pick stocks. Excellent fee-only advisors are out there, but many have minimum account sizes of $200,000 or more, which rules out the overwhelming majority of Canadians.

The situation is somewhat different in the US, where investors have more options, but Dan Solin’s take on the DIY-or-advisor question holds up pretty much anywhere. Here are his major arguments:

• If your assets are under $100,000, you may find it hard to find an advisor who will take you on for a reasonable fee. For this reason, as long as you have the ability to build a simple index fund portfolio and leave it alone, you would be better off on your own.

• If an advisor says he or she can help you beat the market, that’s a dealbreaker. “It’s one thing to decide you need assistance,” Solin writes. “It’s another to use a broker who transfers your wealth into his or her pocket.”

• Only go the DIY route if you are sure you have the necessary discipline. It’s easy to stick to the plan in a bull market, but an awful lot of investors panicked in 2008–09, and plenty more are doing so now. Solin points out that well-advised investors had appropriate asset allocations that allowed them to endure the volatility.

• Consider using an advisor “if you want continuity with your investments for your spouse and family when you die.” If you’re the only one managing the money and you get hit by a bus, is your partner going to be left to the sharks?

• An advisor can be extremely helpful in managing a portfolio for maximum tax efficiency. In Canada , this is especially true for retirees who are dealing with forced withdrawals from RRIFs and trying to avoid Old Age Security clawbacks and other benefits for seniors.

• If you’re a strong believer in the Fama-French principles, you may want to use Dimensional funds, which are only available through a select group of advisors (yes, Solin is one of them). Although you can capture some of these premiums using ETFs, Dimensional funds have a long track record of outperforming traditional small-cap and value index funds.

I tend to agree that passive investors who want to work with an advisor should look for one who uses Dimensional funds. It’s not just that these are excellent, low-cost funds. The real benefit is that the advisors who sell them get it. Solin quotes a Morningstar study that found “advisors who use DFA encourage very smart behavior among their clients.” ETFs can also be excellent tools, but many advisors use them for tactical asset allocation, sector plays and a lot of other nonsense that has nothing to do with passive investing.

As Solin reminds us, investing is about process, not products.

There comes a time in every Couch Potato’s life when he or she has to answer a nagging question: can I do better? Sure, the three or four plain-vanilla funds in the Global Couch Potato have an excellent track record. But they’re just so dull. Surely you can squeeze out even better performance with a more sophisticated portfolio.

Financial advisor and author Dan Solin hears the question all the time. His previous book, The Smartest Investment Book You’ll Ever Read (Viking, 2006) is one of my recommended reads for new or would-be passive investors. That book, he writes, “spawned tens of thousands of savvy investors. They wanted to know if there was any way to improve the returns of the index fund portfolios I recommended.”

The answer is the basis of Solin’s newest book, The Smartest Portfolio You’ll Ever Own (Perigee/Penguin, 2011). It takes things one step further—actually, it takes things two factors further. The book explains how index investors can use the Fama-French Three-Factor Model to tilt their portfolios to value and small-cap stocks.

A new dimension in ETFs

Solin is an adviser who uses Dimensional Funds, which are built on the Fama-French principles. As he explains, value stocks and small-cap stocks have historically delivered higher returns than the overall market, albeit with correspondingly higher volatility.

Dimensional Funds are available only from a select group of advisors, so Solin’s “SuperSmart Portfolio” is designed for do-it-yourselfers who want to use a similar strategy. His model portfolio is made up of both ETFs and Vanguard mutual funds—but since the latter are not available to Canadians, I’ll substitute the equivalent ETFs. This is his suggestion for an investor with a moderate risk tolerance:

.
Solin devotes a lot of space to the historical returns of his SuperSmart Portfolio. Backtestsing always needs to be viewed with some skepticism, but his assumptions here are reasonable. He uses actual fund returns wherever possible (some Vanguard funds go back to the 1990s), and otherwise he uses data from the indexes they track, minus the fund’s current fee. Given that Vanguard and iShares have excellent records of keeping tracking errors low, this is not an unfair comparison. Readers may be surprised to learn that the above portfolio’s annualized return for the 10 years ending in 2010 was 6.54% (in US dollars). So much for the lost decade.

The SuperSmart Canadian

Faithful readers will be aware that I too have designed an ETF portfolio to capture the small and value premiums: the Über-Tuber. It’s the most complex of my model portfolios, but it may be suitable for investors with at least $100,000—preferably more. (Incidentally, Solin suggests the same minimum account size for his SuperSmart Portfolio.) An advisor who uses Dimensional funds recently ran some backtests on the Über-Tuber and found that it would have done a good job of capturing the small and value premiums for Canadian investors over the last 15 years. (Again, the usual caution about backtesting applies.)

One of the main differences between Solin’s portfolio and my own is that he suggests putting half of your fixed income in international bonds, without currency hedging. Many portfolio managers advise against taking currency risk on the bond side: in fact, Solin’s suggestion goes against the opinion of Dimensional Fund Advisors, who recommend using currency hedging as part of their fixed income strategies.

The final section of the book deals with the question of whether index invetsors need an advisor. I’ll discuss Solin’s ideas on this topic in my next post.

We’re accustomed to thinking of choice as a good thing. But behavioural economists now understand that too many options can lead people to make poor decisions—or sometimes no decision at all. In her outstanding book The Art of Choosing (Twelve, 2011), Toronto-born Sheena Iyengar shares a story about how this affects investors.

In 2000, Iyengar, a professor at Columbia Business School, published a now-famous study in which undercover researchers set up tasting booths in a grocery store. Sometimes the booths displayed six flavours of jam, while other times they displayed 24 flavours. Shoppers were 50% more likely to be drawn to the large display. However, those who visited the booth with only six flavours were 10 times more likely to buy a jar of jam.

The following year, Iyengar got a call from a researcher at Vanguard. He wanted to know why the percentage of people enrolling in employer-sponsored retirement plans was steadily declining, even as the number of fund options was on the rise. He’d read the jam study and wondered whether something similar was at work.

Iyengar and her colleagues examined Vanguard’s data and found that the highest rate of participation (75%) was among employees who had just four funds to choose from. Only 70% joined their retirement plan if they were offered a choice of 12 funds. And those who had the “privilege” of choosing from a menu of 59 funds had the lowest participation rate of all: just 60%. Iynegar suggests that employees with more choices were so overwhelmed that they put off their decision, perhaps planning to do the research later. But then they never got around to it.

More options, fewer good decisions

The problem wasn’t just inaction: many employees who did participate in their retirement plans made less than optimal decisions. Even though most of the available choices were equity funds, people with the most options were the least likely to put their money in stocks. Instead, they chose from the smaller list of bond funds, or selected the money market option. “It seems that learning about all the funds was too complicated,” Iyengar writes, “so people tried to reduce the options by pushing the largest category—stocks—to one side.”

I think of these findings as I watch the number of ETFs in the marketplace continue to grow—there are now over 200 listed on the TSX alone, and hundreds more are available from US providers. Some of the new products have been good for index investors. But for the most part, they’re more likely to confuse people who are just beginning to take control of their own finances. Faced with a dizzying number of ETF choices, they may be inclined to just stick with the overpriced, underperforming mutual funds their advisor sold them.

Don’t let this happen to you. If you’re a new investor, or if you’re considering switching to an index strategy, never forget that selecting specific ETFs or index funds is not nearly as important as choosing a suitable asset allocation and taking action now. If you don’t know where to start, see my Model Portfolios page and select the Global Couch Potato or, if your portfolio is large, the Complete Couch Potato. Get moving now, before you get distracted. It’s the most important investment choice you’ll ever make.