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 also 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:

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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 Advisers, 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.

Among academics, the active-versus-passive debate often centres on mutual funds. But among DIY investors—who readily concede that mutual funds with high fees are unlikely to outperform an index strategy—the discussion usually focuses on stock picking. Many people who shun mutual funds believe that building their own portfolios of individual stocks offers a high likelihood of market-beating returns.

At a recent symposium in Toronto hosted by Dimensional Fund Advisors, I listened to financial author Larry Swedroe discuss this idea and others in his book The Quest for Alpha. Swedroe also spoke the night before to a group in Ottawa that included several bloggers. Some were put off by Swedroe’s assertion that investors should not be picking individual stocks.

It’s impossible to make sweeping conclusions about the performance of retail investors who pick stocks, because the data are hard to get, at least compared with what’s available in mutual fund databases. Any researcher can look up the performance of funds, but how can we possibly know how successful individuals are?

Here’s what we know

In fact, there have been a number of studies by researchers who had access to account data from brokerage firms, and some of these are discussed in The Quest for Alpha. The most influential work has been done by Brad Barber and Terrance Odean in California, who have been at it since the 1990s. You can read Swedroe’s book for a summary of the research, or track down the individual papers, but the findings are about what you would expect. Investors routinely underperform risk-adjusted benchmarks, and the less they trade the better they do. Perhaps this quote from Odean sums up the research best: “The point seems to be that individual investors for the most part shouldn’t be trying to pick stocks. They did worse than if they had been throwing darts.”

Swedroe also raises another important issue: most individual investors, whatever strategy they happen to use, don’t know how to measure their performance. There is plenty of anecdotal evidence for this—just read my previous post about yield on cost, or go to any investment show and ask people if they’re beating the market: all of them will say yes. But anecdotes are not evidence, so Swedroe again goes to the research.

In a 2007 study, Markus Glaser and Martin Weber got access to online brokerage accounts and then asked the investors a series of questions about their own performance. Swedroe summarizes the findings both in the book and on his blog, and they are alarming. Echoing Barber and Odean’s work, the study found rampant overconfidence and consistent underperformance among investors who dramatically overestimated their returns. Four out of every five investors who had negative returns were unaware they had even lost money.

Tarring with the same brush

The research is clear that the overall performance of individual investors is worse than that of high-priced mutual funds. You might conclude from these studies that stock picking is an entirely futile exercise. But I would argue that’s too ham-fisted. What the studies show is that investors who trade too frequently get clobbered. There is no doubt that experienced, educated investors will perform much better than the average person in these studies—indeed, Glaser and Weber state this explicitly in their paper.

In my last post, I argued that disciplined, patient and courageous investors (to use Tom Bradley’s words) can do just fine if they stick to low-cost, well-run active mutual funds. Surely the same is true for stock pickers with those same traits. If they diversify properly, keep turnover extremely low, stay invested during the rough times, and control their emotions, they’re unlikely to go too far wrong—even if they don’t end up beating the market.

I’ve been surprised to hear how many investors use some combination of indexing and stock picking, and who seem to be making it work. If you find a purely passive strategy impossible because you can’t make peace with the idea of buying the whole market, then a side order of stock picking probably makes sense. If the comfort of holding individual stocks is what makes you adhere to your investment plan, then there is enormous value in that.

I’d still like stock pickers to read Swedroe’s book, so I’ll send a free copy to the reader who leaves the most interesting comment below. Rather than simply pulling a name from a hat, this is one contest I’m going to actively manage.

I’ve never been shy about criticizing actively managed mutual funds, but I’m starting to think this debate is getting old. More than that, I feel like it’s driving a wedge between people who should be allies. So let me be the first to extend an olive branch and say that the active v. passive debate is too often a distraction from what’s really important in personal finance.

I’ve been thinking about this issue since reading Tom Bradley’s It’s Not Rocket Science, which the author has made available for free. Bradley is president and co-founder of Steadyhand, a small firm that offers a family of low-cost mutual funds sold directly to investors.

A fundamental part of Steadyhand’s investment philosophy is that an active manager’s best chance to beat the market is to ignore index benchmarks and build concentrated portfolios. They even call their strategy “undexing.” So you might expect that a committed passive investor would be filling the margins with indignant notes when reading a book by someone with such confidence in active management. But here’s the thing: I agree with about 95% of what Bradley writes.

One of the first pieces in the book—which is a collection of Bradley’s past blog posts and Globe and Mail columns—is called “Three Keys to Investment Success.” He identifies these as the discipline to set financial goals and decide on a strategy to reach them, the patience to recognize that investing is a marathon and not a sprint, and the courage to stick with your strategy amid the noise of the markets and the media.

Notice that the ability to pick winning stocks or forecast the economy doesn’t even show up on the list (maybe it was the fourth key). In fact, security selection barely comes up in the book at all. Rather, Bradley focuses on the importance of temperament, smart risk-taking, keeping your costs and turnover low, ignoring short-term results, and being suspicious of the charlatans in his industry. When he does get specific about his investing strategy, he writes about the crucial role of asset allocation, and urges Canadians to shake off their home bias and invest globally. Even the most starchy Couch Potato would agree with virtually every word.

Bradley believes that active managers can add value by making tactical shifts in asset allocation—though not too often, and always within a fairly narrow range. And even then, he writes, “For investors who don’t have the wherewithal or inclination to outguess their long-term targets, it’s best to set the portfolio mix and keep it there.” You’d have to be a pretty ideological index investor to argue strongly with that.

The 5% we disagree on

So where do we disagree? The Steadyhand equity funds are concentrated in a small number of stocks—as few as 17 in their Small-Cap Equity Fund. Bradley argues—correctly—that an active manager trying to beat a benchmark index has little hope of doing so if he simply buys most of the stocks in that index. Funds that do this wind up acting like an index fund, but with a higher fee, which is a lethal combination. A low-cost concentrated portfolio has a greater likelihood of outperforming the market than a high-fee index hugger. Fair enough.

I would counter that the evidence suggests the odds of even a low-cost concentrated portfolio delivering long-term, risk-adjusted outperformance are still not very good. But that’s the extent of our philosophical differences, and at the end of the day, this point doesn’t matter as much as we might think.

The fact is, if Canadian investors are suffering from chronic underperformance, it isn’t because their portfolios are actively managed per se. The problem is that most investors pay too much for active management, largely because the fund industry is driven by commissioned salespeople. Disciplined, patient and courageous investors can do just fine if they stick to low-cost, prudently run active funds, whether they are from Steadyhand, or Mawer, or Phillips, Hager & North. I have little confidence that these investors will beat the market consistently, but you could make the same argument about many of the overpriced ETFs and index funds available in Canada.

More important, as Bradley argues with both wisdom and wit, investors are usually their own worst enemy. They sabotage themselves with overconfidence, myopia and an inability to keep their emotions in check. The Couch Potato strategy is designed specifically to minimize these behavioural problems, but I accept  that it can never eliminate them.

The active v. debate still matters, but it isn’t the most important issue in an investor’s success or failure. I think it’s time we all stopped acting as though it were.

In 1951, a Princeton University student wrote a thesis about the mutual fund industry. “Funds can make no claim to superiority over the investment averages,” wrote the scholar, who would go on to create the first index mutual fund some 25 years later. That young man, of course, was John Bogle, founder of The Vanguard Group and the subject of The House that Bogle Built (McGraw-Hill Ryerson, 2011), a new biography by journalist Lewis Braham.

With the news that Vanguard has arrived in Canada, this book seems like timely summer reading. Not only does it paint a vivid portrait of one of the most important investor advocates of all time, but it also peers inside the unique organization he founded—a company that has been steadily drifting away from the vision of its first chairman.

“A long-term loser”

In a chapter called “The Devil’s Invention,” Braham explains what Bogle endured in 1976 when he launched the First Index Investment Trust, which would later become the Vanguard 500 Index Fund. The idea was so slow to catch on that it could not even afford to buy all the stocks in the S&P 500. Competitors mocked the very idea of a fund designed to match market returns—one called it “a formula for a solid, consistent, long-term loser.” Today that fund has $112 billion in assets, and once you account for survivorship bias, it has outperformed more than 90% percent of its competitors over the last quarter of a century.

Although Vanguard pioneered index investing and still manages some of the largest and best passive funds, the company has evolved since Bogle stepped down as chairman in 1996, after he received a heart transplant and appeared close to death. In one of the most personal chapters, Braham describes Bogle’s relationship with Jack Brennan, Vanguard’s CEO until 2009. Brennan was once a beloved protégé of Bogle’s, but the two men had a falling out and now appear to despise one another, though the specific reasons remain known only to their inner circles.

At least part of the tension must have arisen from Bogle’s almost ideological devotion to index mutual funds. Braham explains that in 1991 Bogle was approached by a product developer who had an idea for an index-tracking fund that would trade like a stock. “Bogle sent him packing, arguing that a tradable index fund would defeat the purpose of indexing,” he writes. That product would eventually be launched as the SPDR S&P 500 (SPY), nicknamed “Spiders,” one of the first and still one of the largest ETFs in the world.

Even 20 years later, Bogle remains critical of ETFs because of the way they encourage frequent trading. It’s opinions like these that can make him sound sanctimonious, and it’s perhaps not surprising that he’s had an uneasy relationship with the current Vanguard brass. About 30% of Vanguard’s assets are now in actively managed funds, for example, and the company markets itself heavily, something that makes Bogle cringe.

Saint and sinner

Braham’s portrait of Bogle is admiring, but not uncritical. The man they call “St. Jack” comes across as a bit of a media hound who loves the limelight, and he appears to have a towering ego. In one telling passing in the last chapter, Braham catalogues the honorary degrees and other accolades Bogle has received and quips, “Are you reading this, Jack?”

If there’s one element of the book I’d take issue with, it’s the second-last chapter, called “The Future of Indexing.” Here Braham looks at the flaws in traditional cap-weighted index funds. He spends a lot of time arguing in favour of fundamental indexing and even pines for an index fund that would make tactical shifts in asset allocation based on valuations. It’s odd to hear an author make comments like this after devoting so much space to describing just how well Bogle’s plain-vanilla index funds have stood the test of time.

But this is a small quibble—as are Bogle’s own imperfections. In an industry that has become the standard-bearer of greed and exploitation, he has been a tireless champion of the little guy for almost four decades. All investors owe Jack Bogle—now 82 and still going strong—an enormous debt of gratitude for the work he has done on their behalf. Lewis Braham’s candid portrait is fine chronicle of that legacy.