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.

The Couch Potato strategy thrives on simplicity, but advanced index investors (geeks) should understand what goes on under the hood of ETFs. One of the most important concepts is how ETF shares are created and redeemed. I’ll warn you that this gets a bit technical. But it turns out that this process is the single most important difference between ETFs and index mutual funds.

Let’s begin by looking at how a mutual fund creates new shares (or units). When you make a $2,000 contribution, your money goes directly to the mutual fund’s manager, who uses it to buy more securities. If the fund’s net asset value (NAV) per share is $20, the manager then creates 100 new shares ($2,000 ÷ $20) just for you. This is what’s meant by the term open-end fund: the number of units changes every time money moves in or out.

Closed-end funds, by contrast, do not create or redeem new units. They are launched with a finite number of shares, and if you want to invest in the fund you have to buy your shares from another investor who is willing to sell.

An open-ended discussion

ETFs trade on an exchange like closed-end funds, but they are open-ended: new shares are created to meet investor demand. Unlike mutual funds, however, ETFs do not create new units every time money flows in.

Instead, whenever necessary, ETF providers issue a large block of shares called a Prescribed Number of Units (PNU), typically in multiples of 50,000. The providers then work in partnership with third-party “designated brokers,” or DBs, who distribute these units to the public. A new ETF might be launched with 200,000 units, for example, and several DBs would  divide these up and sell them on the secondary market. Going forward, when invetsors want to sell their units, the DBs are obliged to buy them back at a price very close to their net asset value.

(Geeky footnote: ETF providers south of the border use different terminology. If you’re reading American books or websites, PNUs are called creation units, and designated brokers are called authorized participants. Feel free to share this fun fact with your friends and coworkers.)

When you purchase $2,000 worth of an ETF trading at $20, the DB will simply fill your order with 100 shares from its inventory. However, if an institutional investor wants to buy $2 million worth of shares, the DB will not have enough inventory. So it will credit the investor’s account for 100,000 shares and simultaneously purchase $2 million worth of the fund’s underlying holdings. Then the broker will deliver that basket of stocks or bonds to the ETF provider, who will create 100,000 new shares and send them to the DB as payment.

That wasn’t so hard, was it?

Redeeming qualities

This creation-redemption process may be complicated, but it has a couple of important benefits.

First, if the ETF is selling at a premium, a designated broker can buy the fund’s underlying securities and simultaneously sell shares of the ETF, thus making a risk-free profit. (If it is selling at a discount, the DB can do the opposite.) This presents an arbitrage opportunity, and when multiple DBs compete with each other to profit from it, the result is that the ETF’s price stays close to the NAV. That, of course, is exactly what investors want.

Second, the process prevents buy-and-hold ETF investors from being penalized by active traders. An inherent problem with mutual funds is they must always keep cash on hand to pay investors who redeem their shares, and this uninvested money is a drag on the fund’s returns. Worse, when investors sell in droves (such as during a market decline), the mutual fund has to liquidate holdings to pay them, which can mean forced sales and tax consequences for the fund’s other investors. ETFs never have to do this: if investors flee, the designated broker can just return blocks of shares to the ETF provider and receive the underlying securities in exchange. Because this is an “in-kind redemption” and not a sale, there is no taxable event.

For more information about the nuts and bolts of ETF construction, I recommend All About Exchange-Traded Funds, a new book by Scott Paul Frush (McGraw-Hill, 2011).

When Vanguard announced its arrival in Canada this summer, investors welcomed the company with open arms: perhaps no country would benefit more from Vanguard’s devotion to low-cost investing. The company’s first Canadian ETFs started trading on the TSX on December 6.

On the day of the launch, I had the pleasure of sitting down with Atul Tiwari, managing director at Vanguard Investments Canada; Dennis Duffy, Vanguard’s director of business development for non-US markets; and Joel Dickson, a principal in Vanguard’s Investment Strategy Group.

Here are some highlights from the interview dealing with Vanguard’s overall strategy in Canada. Later this week I’ll run another excerpt that focuses specifically on the new ETFs and Vanguard Canada’s plans for the future.

Why did you decide to enter the Canadian market with ETFs rather than mutual funds? And why did you target advisors rather than retail investors?

AT: Having looked at the Canadian market for at least 14 or 15 years, Vanguard considered a number of different entry strategies. The reason we executed now is that the Canadian marketplace is changing. We are seeing a lot more advisors moving from a commission-based approach to a fee-based approach, and that fits in squarely with the Vanguard model. We don’t pay for distribution anywhere in the world, so to enter the Canadian market with mutual funds would be kind of tough, because it is a very commission-oriented business.

About 20% of advisors’ overall business in Canada uses a fee-based model, whereas in the US it is about 65%. Canada is probably where the US was about eight years ago. The other thing is, there are a lot of regulatory changes going on globally. By the end of next year, commissions will essentially be banned in the UK. Same thing in Australia. In the US, they are discussing the fiduciary standard for brokers, and even the OSC [Ontario Securities Commission] has said recently that they are going to consider a fiduciary standard. So with a little help from the regulatory changes, we think we will be well-positioned.

What were some of the uniquely Canadian challenges that you faced? For example, low-cost, direct-sold mutual funds are extremely popular in the US, but investors in Canada haven’t really embraced them.

AT: You’re absolutely right: a number of companies have tried, but direct-sold funds just haven’t caught on in Canada. And a lot of that is because mutual funds are sold and not bought. We haven’t got any plans to launch mutual funds at this stage, but that is not to say that in the future we won’t. We entered the market with the product that we thought would be the best entry point for Canada, and that is ETFs.

One of our other challenges—and certainly one of the key components of our Canadian strategy—is investor education. We will be doing a lot of thought leadership, a lot of seminars—we will do whatever we can to get the message across to investors and advisors about the effects that costs have on your returns over the long run.                                  

Index investors are well aware of the benefits of low costs. But how do you make that case to advisors?

DD: This has been a challenge for us in every market. Even before ETFs, we had a pretty significant advisor business in the US, but the fee-based business was a relatively small percentage of the overall market back in the early 2000s. We went into the UK prior to the legislation banning commissions: we felt there was enough fee-based business there, and we were willing to make the commitment. We are very patient company: look at how long it took us to get into Canada! But there is a lot of education that is going to be needed.

JD: It’s important to recognize that the advisor’s compensation doesn’t need to change at all [if they start using Vanguard ETFs]. Even if they are getting 1% or 1.5% or whatever for their services, we would hope that there is an opportunity to lower fund costs: if you can show 24 basis points with your ETF holdings as opposed to another 1.5% on underlying mutual funds, that’s a huge benefit.

Yet many advisors—and their clients, for that matter—continue to insist that active management is part of their value-added, despite overwhelming evidence to the contrary.

JD: That is a key issue: the value-added model has been disrupted. We talk about a concept we call advisor’s alpha, which is to say, how do you as an advisor position your value to clients in a world where it is not about picking the best funds, or the best managers? It’s about focusing on things you can control, like costs, and risk, and taxes and behaviour.

The problem is, these things are sometimes hard to measure. Some of the best “performance” an advisor could have provided came when the client called them up in the depths of the market in 2009 saying, “Get me out now!” and the advisor said, “Remember our overall asset allocation for the long run?” That doesn’t show up on your statement as the performance of your portfolio versus some benchmark. But if the investor would have sold out on their own, there is huge value added.

No new models yet

Many readers have emailed to ask me whether I will be updating my model portfolios with the new Vanguard ETFs. I’m not planning to do that just yet—for a couple of reasons.

First, the funds have been trading for only a couple of weeks, and while I have little doubt that Vanguard will do a good job keeping tracking errors and bid-ask spreads low, I would like to wait and see.

Second, Vanguard Canada’s US and international equity ETFs use currency hedging, which I have avoided in my model portfolios. It is possible that Vanguard will eventually launch unhedged versions of these ETFs, at which point I would be more likely to incorporate them.

I am resisting the urge to tinker with the model portfolios every time new ETFs are launched. However, this time next year I will re-evaluate the marketplace, and it’s likely that I’ll make some changes to the portfolios to reduce their cost.

Quicken winner

Thanks to everyone who entered the draw for the copy of Quicken Home & Business 2012 money management software. The lucky winner is Chris, who contributes some of the wisest comments on this blog. Congratulations!

In the spirit of holiday giving, Justin Bender, portfolio manager with PWL Capital in Toronto, has approached me with an offer for Canadian Couch Potato readers. As part of his firm’s charitable giving program, Justin is offering to help up to four DIY investors design and set up a passive ETF portfolio in exchange for a donation to the Centre for Addiction and Mental Health (CAMH).

One of the reasons I wrote The MoneySense Guide to the Perfect Portfolio was to help the many would-be Couch Potatoes who are not sure how to get started with DIY index investing. Now here’s an opportunity to have a professional walk you through the process, and to support an organization that does incredibly important work.

Before you dismiss this as a thinly veiled attempt to snag new clients, let’s be clear that Justin is looking to work only with do-it-yourself investors on a one-time basis. His goal is to help you design a plan that you will execute on your own, not to manage your assets on an ongoing basis. There’s no ulterior motive here. PWL’s Toronto office has made a commitment to support CAMH because one of the firm’s staff members lost a close family member who struggled with addiction and mental illness.

How to get started

Here’s how it works. If you’re interested in participating, contact Justin at jbender@pwlcapital.com. He will discuss your investment goals and your financial situation to make sure it’s straightforward—and that it’s something you can handle on your own going forward. If you decide to work together, then you agree to make a donation to CAMH of $1,000 to $2,500, depending on the amount of work involved. Keep a copy of the receipt as proof. Of course, the donation will earn you a tax credit, so a $2,500 may end up costing just $1,500 in pre-tax dollars.

[Update on December 14: Justin received a number responses to this offer, netting almost $10,000 in donations for CAMH. He is able to take on just one more client for $2,500.]

The ideal candidate would be someone in the wealth accumulation phase of life—say, early 50s or younger—rather than someone who is drawing down their portfolio. (Retirees in that situation face complex tax issues and probably shouldn’t work on their own.)

Justin will put together an investment plan for you, including determining your target rate of return, an appropriate asset allocation, suggesting specific ETFs, and a rebalancing schedule. Then he’ll walk you through the process of placing the orders as you build your ETF portfolio. He can work with the brokerages of all Big Five banks, and he will help you open the appropriate types of accounts and transfer any securities from existing accounts, if necessary. Then you take over from there—no strings attached.

Ideally, you should be prepared to pay a visit to Justin at his Toronto office. However, he is licensed to work with investors in other provinces, so if you’re comfortable working by phone and email, he’s willing to do that as well.

If you’ve been planning to rebuild your portfolio but you’re nervous about pulling the trigger, this is an opportunity to get a helping hand from a professional—and to help a great cause. It would also make an excellent holiday gift from a parent to an adult child who is just getting started on the road to investing.

To make sure you’re comfortable managing your portfolio on your own, I will throw in copies of my book to any investor who participates.

For several years now, I’ve been encouraged that Canadians are coming around to the idea that trying to pick winning funds or this year’s hot asset class is a loser’s game. And then I read something like Gordon Pape’s recent Fund Library article, ETF Winners,  and I realize that we have a long way to go.

The article looks at the “outstanding performances” of three ETFs this year: the Claymore Gold Bullion (CGL), the Horizons COMEX Gold (HUG) and the iShares S&P/TSX Capped REIT (XRE). What makes these funds winners? They had the highest returns, of course.

For a distressingly large number of media commentators and investors, recent performance is still the only criterion that matters. If you invested in gold and real estate this year, you were a winner. If you owned a globally diversified portfolio of stocks, you were a loser. Better luck next time.

Let’s start by pointing out that the three ETFs that Pape names are passively managed. So the fact that gold had another great year and real estate outperformed other sectors does not make these particular funds “outstanding” in any way. The measure of any passive ETF is how well it tracks its index, regardless of whether that asset class has a good year or a lousy one. If these ETFs had large tracking errors (for the record, they did not), their absolute returns would still have been very high, but they would have been losers for not delivering on their mandate.

I realize this kind of thinking doesn’t come naturally to most investors who focus only on outcomes. But if you’re going to be a Couch Potato investor, you need to understand the best investing strategy is the one that gives you the highest probability of long-term success. It’s not the one that would have delivered the highest return over the last 12 months, because that is always unknowable in advance and has no bearing on the future. Identifying winners and losers after the fact is a favourite pastime of the financial media, but it has absolutely zero value to investors.

A bad sailing metaphor

Think of investing as a journey across the ocean. As a passive investor, you’ve decided to travel in a well-built sailing vessel designed to capture as much of the prevailing winds as possible, with a hull that glides through the water with a minimum of drag. You know a ship like that is likely to arrive at your destination more swiftly and efficiently than a small motorboat. But you need to be prepared for the inevitable days where there is no wind, and for the gales that will temporarily blow you backwards. During these periods, it makes no sense to kick yourself for not buying an outboard.

Clearly many people disagree: they think it makes more sense to try to predict the direction of the wind, and to jump from boat to boat. “I have always believed that ETFs are much better trading vehicles than buy-and-hold funds,” Pape writes in his article, “and the mediocre performance of the Couch Potato Portfolio that we have been tracking on the Fund Library bears this out.”

This logic is flawed from the start. It’s mathematically impossible for a diversified portfolio to outperform the year’s hottest asset classes. By design, a Couch Potato portfolio will always fall somewhere in the middle of the pack over short periods, but over the long term it is likely to beat the vast majority of active strategies. That’s not good enough for some investors. Instead, they feel they must move in and out of asset classes in search of the “winners.”

How hard can that be? Have a look at this periodic table of investment returns, which shows the best and worst performing asset classes over the last decade. Do you see a pattern? Think you can use this information to predict the top asset class of 2012? I know I can’t, and neither can anyone else. But I have no doubt we’ll be able to read about next year’s winners after the race is over.

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.

Let’s end the week with one final post about the Permanent Portfolio. Many readers expressed interest in this strategy, introduced by Harry Browne in the early 1980s. I’ve spent so much time on the Permanent Portfolio because I find it fascinating, and I enjoyed discussing its subtleties with Craig Rowland, who has studied it extensively. I’d like to thank Craig for taking so much time to answer readers’ comments so thoroughly over the last couple of weeks.

There are many things I like about the Permanent Portfolio, especially that it’s a passive strategy based on asset allocation and diversification, rather than forecasting or security selection. I also think it’s extremely low volatility is perhaps the best example of Modern Portfolio Theory in action. But I can’t encourage investors in Canada to adopt the strategy. Here’s why:

• With just one quarter of the portfolio allocated to stocks, I don’t feel there is enough potential for long-term growth. Stocks have delivered—by far—the highest real returns over the 85-plus years for which we have good market data. Yes, they are volatile, but they have historically rewarded long-term investors with excellent growth in a way that cash, gold and government bonds have not.

• Long-term bonds may be a hedge against deflation, but we have not seen significant deflation in Canada since the Great Depression. That’s not to say it can’t happen, of course, but the probability of it occurring does not justify such a large place in a portfolio. A 40% allocation to an index fund tracking the broad Canadian bond market would give you about 10% long bonds, 10% intermediate, and 20% short, with about a third of these in corporate bonds. This kind of diversified fixed-income portfolio offers a better risk-reward trade-off.

• Gold can be a stellar performer during times of crisis, and I would never argue with an investor who kept a small holding (no more than 10%). But the idea that it is a hedge against inflation in the traditional sense—that is, in the sense of rising prices, as opposed to catastrophic hyperinflation—just isn’t borne out by the data. If our currency ever collapses I’ll regret not holding gold, and I can’t argue that will never happen. But in my opinion, the probability does not justify a 25% allocation.

• Cash is not an investment: it’s savings. It’s perfectly prudent to keep cash on hand as an emergency fund, especially if you feel that a job loss, illness or other unexpected event would put your lifestyle in jeopardy. Perhaps that’s three to six months’ worth of expenses for a working family, or maybe as much as a two-year cushion for a retiree. But should someone with a $400,000 portfolio keep $100,000 in cash, where its real return is unlikely to be much more than 0%? The opportunity cost would be enormous.

Another look at the returns

One of the reasons that the Permanent Portfolio has gained popularity recently is that its returns have been impressive over the last dozen years or so, a period when stocks have performed poorly. And it’s not just the medium-term results that look impressive: according to the historical performance data on the Crawling Road website, the annualized return on the portfolio was 9.7% from 1972 through 2008. The page doesn’t include the data for 2009 and 2010, but the returns in both of those years was higher still.

How would the Permanent Portfolio’s returns have stacked up against a traditional index portfolio? Justin Bender, a CFA and adviser with PWL Capital in Toronto, was kind enough to run these numbers, and he’s allowed me to pass on the results to readers. You can download the Excel spreadsheet here.

Justin analyzed the Permanent Portfolio using Canadian data for T-bills (cash), gold and long-term bonds. For the stock allocation he used an even split of Canadian stocks and the MSCI World Index. Then he compared it against the Global Couch Potato’s allocation of 20% Canadian stocks, 40%  U.S. and international stocks (also using the MSCI World Index), and 40% Canadian bonds (all maturities). He was able to get data going back to late 1979.

The Excel file includes three worksheets:

• The first indicates the volatility of the two portfolios. Justin measured the portfolios’ standard deviation over rolling three-year periods. You’ll notice that the Permanent Portfolio’s volatility is extremely low: it averages about 5.6%, compared with 8.5% for the Global Couch Potato.

• The second worksheet gives the annual returns for the two portfolios. From 1980 through 2010, the Permanent Portfolio’s compound annual growth rate was 8.42%, compared with 10.32% for the Global Couch Potato.

• How much difference did that added 1.9% a year make, compounded over more than 31 years? The final worksheet graphs the growth of $1 invested in each portfolio from December 1979 through June 2011. Each dollar invested in the Permanent Portfolio would have grown to $13.77. One dollar invested in the Global Couch Potato would have become $21.92.

In the midst of the meltdown yesterday, I got an email from my wife. Several of her work colleagues had been discussing the carnage in the markets and she was worried: our daughter will start university next year, and my wife wanted to make sure our RESPs would survive another crash.

The answer was yes, of course. Knowing that we’ll need about $15,000 this time next year, I’ve set aside that amount in cash. Another 60% of our daughter’s RESP is in bonds, with the duration carefully matched to our time horizon. The account has less than 15% in equities, which I will move to fixed income over the next couple of years. With that asset mix, even a 50% decline in the equity markets won’t jeopardize our investment plan one bit.

My RRSP, on the other hand, is 70% equities, so it has taken quite a hit over the past few months. I’m not thrilled about that, but since I don’t need the money for at least two decades, this latest market mess is nothing but a speed bump. In fact, I’m trying to scrape together some cash to take advantage of the fire sale.

I’m sharing this little anecdote because it’s a reminder that choosing an appropriate asset allocation is the most important investment decision you’ll ever make. Your portfolio’s overall mix of stocks and bonds not only has to match your comfort level with risk, but also the time horizon of your investment goal.

It’s natural to get spooked during a market crash. But if you’re panicking, if you’re genuinely concerned that your portfolio won’t recover before you need the money, or if you’re tempted to get out before things fall further, then you’ve got an inappropriate asset allocation. You need to reconsider your ability, need, and willingness to take risk.

No surprises

Market turmoil is inevitable: it’s happened before, and it will happen again, so there is no excuse for being blindsided. Anyone who invests in equities—and that includes broad-based index funds—should be prepared to lose half their money. Of course, you can expect to recover eventually, but after a 50% loss, your investment needs to double before you get back to even—and that can take several years of double-digit returns. If you don’t have that much time, then you need to keep most of your portfolio in safer investments, such as short-term bonds and cash. Yes, interest rates are low, but that is the price of safety.

In The Warren Buffet Way, Robert Hagstrom describes the great investor’s advice on this matter: “Unless you can watch your stock holdings decline by 50% without becoming panic-stricken, you should not be in the stock market.”

The road to financial ruin is paved with the bodies of investors who overestimated their ability to take risk. A properly designed investment plan—and a spouse who keeps tabs on you—will make sure you’re not one of them.

This has been a scary few months in the markets, and nervous investors may be tempted to second-guess their strategy. If you’re an indexer, you may be starting to believe that it’s time to reposition your portfolio for the changes that are “certain” to come. Depending on which guru you listen to, that might be high inflation, rising interest rates, a double-dip recession, the collapse of the U.S. dollar, or a long period of poor equity returns. The voices are all shouting at you: This is not a time to be passive!

I thought it would be interesting to put ourselves in the mind of a Canadian investor on January 1, 2001, the start date of the 10-year period I looked at in my Couch Potato report card. You’ll recall that this simple portfolio returned 4% annually during that period, a result that most people would agree was disappointing, even though it beat 86% of comparable mutual funds.

2001: An Investor’s Odyssey

Based on what you knew about the economy and markets in 2001, could you have built a portfolio that would have done better? As you woke up with your New Year’s Eve hangover, here’s the environment you’d have found yourself in:

• Although the dot-com craze was rapidly cooling and stocks had negative returns in 2000, the annualized 10-year return of the S&P 500 was still 20.5% in Canadian dollars. The S&P/TSX Composite was a dog by comparison: it returned about 13% annualized during the same period.

• Emerging markets, the darlings of the late 1980s and early 1990s, were an embarrassment, with negative returns for the seven years from 1994 through 2000.

• If you had bought $1,000 worth of gold 20 years earlier (in 1981) it would have been worth $585 (in Canadian dollars), before adjusting for inflation.

• The price of oil was under $27 USD a barrel and would fall even lower as the year went on.

• The Canadian dollar had declined steadily from $0.88 USD in October 1991 to $0.65 USD at the beginning of 2001.

• Short-term interest rates had been trending steadily downward for years. The return on 90-day T-bills was over 13% in 1990, declining to barely 3% in 1997, before levelling off around 5% over the last three years of the decade.

• Despite this trend of declining short-term rates, recent returns on the overall bond market were about double the historical average. The Scotia Capital Markets Bond Index (the predecessor of the DEX Universe) returned over 10% annualized from 1991 through 2000.

What was the sentiment like at the time? For a clue you can read the speech delivered in January 2001 by Gordon Thiessen, then governor of the Bank of Canada. He concluded his talk with an optimistic nod to “the improvements we have seen in the fundamental, longer-term trends in our economy. Because of these improvements, our economy is now in better shape than it has been for some time to deal with all kinds of external shocks.”

Didn’t see that coming

Now let’s review how things actually played out and decide whether our investor in 2001 might have been surprised by a few things:

• Eight months after Thiessen declared us ready to “deal with all kinds of external shocks,” terrorists crashed hijacked planes in to the World Trade Center and the Pentagon and the U.S. and its allies, including Canada, went to war with Afghanistan.

• The markets plunged in 2001 and 2002 as the dot-com bubble deflated.

• In March of 2003, the U.S. began a second war in Iraq. Oil prices would quadruple by 2008.

• After the dot-com disaster, the next four years (2003 through 2006) saw a raging bull market almost on par with the 1990s: 15% annualized returns in the U.S., and over 20% in Canada.

• The Canadian dollar began a remarkable climb, peaking at $1.10 USD in November 2007, falling back to $0.77 USD in 2009, and then touching $1.06 USD again in 2011.

• Gold doubled in value (in Canadian dollars) from 2006 through 2010.

• The financial crisis of 2008–09 saw some of the world’s largest financial institutions collapse and caused stock-market declines of 40% to 50%, leaving many people to ponder if the global financial system might collapse completely. Then the markets recovered rapidly from the crisis, returning 80% to 90% from March 2009 to the end of 2010.

• The best-performing equity asset class for the decade was emerging markets, which delivered over 11% annualized.

• Interest rates continued to fall, with short-term rates approaching zero in 2009.

The future: Still crazy after all these years

Which of these events could have been anticipated the day that Gordon Thiessen delivered his speech? More to the point, what would have been a reasonable strategy for a Canadian investor assessing market conditions in early 2001?

Well, you would have been a big winner if you had completely abandoned the best-performing asset class of the previous decade (U.S. stocks), embraced others (gold and emerging markets) that had been horrendous for many years, and bet that the pathetic Canadian dollar would increase by about 60%. For good measure, you might have also shorted the U.S. housing market.

Or you might have recognized that it is absurd to think we can predict how the future will unfold, and instead built a globally diversified portfolio equipped to weather anything the market sends its way. It should include thousands of stocks, in all sectors, from dozens of countries, in several currencies. Throw in government bonds of all maturities to provide ballast when equity markets are volatile, and inflation-protected bonds, real estate, and some exposure to commodities.

This kind of strategy carries no guarantee of absolute returns. It simply captures everything the markets have to give, which is all any investor can hope for—unless you believe you can do better with your predictions for the next decade.

A couple of weeks ago, Balance Junkie wrote a post called Why This Is No Market for Couch Potatoes. The main argument of the post—one that has been made many times before—is that passive investing is fine during bull markets, but it likely won’t work going forward because “we are in a secular bear market that began in 2000.”

This argument picks up on previous post, where Balance Junkie referred to passive investors as ostriches who ignore macroeconomic conditions when they invest: “Sticking your fingers in your ears and singing while the markets tank is not a good investing strategy.”

This is a gross mischaracterization of passive investing, but I have to accept part of the blame. Balance Junkie referred to a recent column in MoneySense where I described the strategy as “the investing equivalent of flopping in front of the TV with a bag of Cheetos.” I realize now that there’s a problem with the terminology used by passive investors. Couch Potato, Sleepy, Lazy, Easy Chair, Gone Fishin’, Coffeehouse, Rip Van Winkle—if you miss the irony, it’s easy to infer that indexers have decided investing is just too much work, so they prefer not to think about it. They’d rather spend their time snoozing and just hope it all works out for the best.

So allow me to wipe the orange cheese powder from my lips, get up from the couch and explain why that’s never been true.

The lesson of history

One of the problems with passive investing, Balance Junkie says, is that a “reliance on broad-based historical data ignores the fact that markets experience both cyclical and secular trends over the long term.” Passive investors expect “annual returns of 6% to 8% like clockwork” and therefore the Global Couch Potato’s recent 10-year performance was “somewhat lower than advertised.” She also argues that the best data on past returns only go back to 1926, and “using an 85-year context for a 25-year investment time frame probably won’t be very effective.”

If any index investors are “advertising” absolute returns in the range of 6% to 8%, or expecting any returns “like clockwork,” I would be the first to call them out. Investing isn’t physics. You can say with certainty that the sun will always rise in east, and that a stock broker tossed from a window will always accelerate at 9.8 metres per second squared. But no one can claim that stocks will return 9% and bonds will get 5% over the next 25 years just because those are the historical averages.

But here’s the problem. Anyone with a financial plan has to make assumptions, and that includes expected rates of return. When you come up with these figures, you have two choices: you can look at the historical data, as imperfect as they may be, and use them to make reasonable estimates about asset returns. (If you’re sensible, your estimates will be less than the historical averages to build in a margin safety: most financial planners I know assume stocks will returns about 7.5%.) Or you can dismiss all of the data as irrelevant, declare that everything is different now, and base your assumptions on economic forecasts. Which approach has the greatest likelihood of success?

The point is that passive investors do not ignore that markets experience cyclical and secular trends. They simply recognize that those trends can only be identified with hindsight, and therefore have no value when estimating expected asset returns.

What if we’re wrong?

Balance Junkie says that “passive investors are betting (yes, betting) that markets will be higher in the future.” I suppose we are. But over the last century, anyone with a horizon of 25 years would have won that bet 100% of the time. That century included global war, double-digit inflation, deflation, booming prosperity, recession and depression, currency devaluation, sovereign defaults, high interest rates, low interest rates, asset bubbles, terrorist attacks and disco. Yet over every rolling 25-year period the returns on a balanced portfolio would have held up well. That’s not a guarantee, but I like the odds.

Yes, but “passive investors are forgetting to ask themselves the question that is key to evaluating any decision: What if I’m wrong?” Are we really forgetting to consider this? If we assumed that past returns were guaranteed to continue in the future, we would put all of our money in small-cap value stocks, which have returned almost 14% since 1926. And no long-term investor would ever put a dime in fixed-income, because stocks have always outperformed bonds over periods of 25 years or longer. The fact is, every prudent investor recognizes that even reasonable assumptions may not hold up—and so we diversify.

My own portfolio (the Complete Couch Potato) includes over 10,000 stocks, in more than 40 countries, in several currencies, as well as a significant allocation to real estate, nominal bonds and real-return bonds. The whole idea behind this kind of wide diversification is that any prediction I might make about the economy or the financial markets is almost guaranteed to be wrong.

Forecasts have no value

Balance Junkie suggests that passive investors should spend more time “learning about the stock market and the macroeconomic environment in which we live.” She argues that “it makes sense to adjust your asset allocation according to market and economic conditions.” Let’s set aside the fact that many advocates of passive investing are institutional investors, finance professors and economists. I’ll just respond with the same question she asked about expected returns: What if you’re wrong?

Everyone has an anecdote about the guru who predicted a market crash, or a bubble, or who made a good macro call. But the idea that investors can improve their long-term returns by adjusting their portfolios according to “changes in market structure, macroeconomic fundamentals, and technical cues” flies in the face of the evidence. Most forecasts about markets and the economy are wrong, period.

Rather than try to build this argument myself, I’ll turn things over to Larry Swedroe, who has made it eloquently many times on his blog—backed up with empirical data, as always:

How Much Value Do Economic Forecasts Hold?, April 29, 2009
Why You Should Listen to Economic Forecasts With Caution, August 19, 2009
Forecasting Should Be Left to the Astrologers, July 19, 2010
Don’t Listen to Economic Forecasters, November 24, 2010
How Are 2011’s Sure Things Faring at Mid-Year?, July 19, 2011
Why Basing Investments on Economic Conditions Is a Bad Strategy, July 22, 2011

Passive investing is not for people who are too lazy or dim-witted to understand how markets work, and Couch Potatoes are not Pollyannas who naively throw their money at past performance and expect absolute returns. They are investors who understand that in a world where we cannot predict the future, the most reasonable strategy is to determine the amount of risk you’re willing and able to take, diversify widely, keep costs low and tune out the noise. It’s not a perfect solution, but it has a far better track record than the fortune tellers.

Now pass the Cheetos, please.