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What is the Couch Potato strategy?
The Couch Potato strategy is a technique for building a diversified, low-maintenance portfolio designed to deliver the returns of the overall stock and bond markets with minimal cost. The strategy can reduce a typical investor’s costs by as much as 90%, while at the same time beating the majority of mutual funds and professionally managed accounts.
The strategy—also called index investing, or passive investing—has been around for decades, though it has become far more popular in recent years, as new products and online discount brokerages have made it easier to implement. Anyone can now build and maintain their own portfolio using index mutual funds and exchange-traded funds (ETFs).
What’s an index mutual fund?
First it’s important to understand what an index is: it’s a group of stocks or bonds used to measure the performance of a particular market. For instance, the S&P/TSX Composite includes about 250 companies traded on the Toronto Stock Exchange, and it’s considered a barometer of the entire Canadian stock market.
Similarly, the Dow Jones Industrial Average, the S&P 500 and the Russell 3000 are indexes that measure the US stock market. The MSCI EAFE is a popular index of international stocks. Other indexes measure the fixed-income market, such as the widely used DEX Universe Bond Index, which covers both government and corporate bonds in Canada.
An index mutual fund holds all (or almost all) of the stocks or bonds in a particular index. The idea is to produce a return equal to that of the overall market. That’s different from the goal of “actively managed” mutual funds, which try (usually unsuccessfully) to choose individual securities that will outperform the market. To use a favourite phrase of John Bogle, the father of index investing, instead of looking for the needle in the haystack, index funds just buy the haystack.
What are exchange-traded funds (ETFs)?
Exchange-traded funds, or ETFs, are similar to index mutual funds in that they hold a basket of stocks or bonds and track a specific index. However, unlike mutual funds, ETFs are bought and sold on an exchange, like stocks.
While investors typically pay a commission to buy and sell them (just as they would when trading stocks), ETFs typically have lower annual fees than index mutual funds. There is also a much wider selection, offering investors access to almost every kind of asset: stocks, bonds, real estate, commodities, precious metals, currencies and more.
Where does the Couch Potato name come from?
In a 1991 article, Scott Burns, then a financial writer for the Dallas Morning News, suggested investors simply put half their money in an index fund that tracked the S&P 500, and the other half in a fund that tracked the US bond market. Every year, he said, rebalance the portfolio so it’s once again 50% stocks and 50% bonds. “You need to pay attention to your investments only once a year,” he wrote. “Any time it’s convenient. Any time you can muster the capacity to divide by the number 2.” He called his ultra-simple investment idea the “Couch Potato portfolio.”
When MoneySense magazine was launched in 1999, founding editor Ian McGugan brought the Couch Potato to Canada. Since then, MoneySense has remained a leading source of information about index investing, especially through the features and columns of Dan Bortolotti.
How can such a simple strategy beat the pros?
To many investors, the idea that the Couch Potato strategy can beat most professional money managers seems ridiculous—as though someone were selling a golf strategy that could beat most players on the PGA Tour. The difference, however, is that pro golfers routinely shoot under par, while most mutual fund managers underperform the overall market. Standard & Poor’s reports that over the five years ending in 2011, 97.3% of actively managed Canadian mutual funds failed to deliver better returns than their benchmark index.
Rather than paying money managers high fees to try in vain to beat the market, Couch Potato investors simply aim for market returns at the lowest possible cost. After all, no one needs to beat the market to be a successful investor. Investors who save diligently and simply earn market returns should have no trouble reaching their financial goals.
Why is my advisor trying to talk me out of it?
Indexing strategies are used by the most sophisticated pension and endowment fund managers in the world, and many of its proponents are Nobel laureates. Yet many financial advisors are contemptuous of the idea. The reason is simple: advisors often make their money from commissions and fees on the investment products they sell. As Upton Sinclair wrote, “It is difficult to get a man to understand something when his salary depends upon his not understanding it.”
Many investment firms don’t even offer index funds (they’re not profitable enough), and many mutual fund salespeople are not licensed to sell ETFs. If you want to adopt a Couch Potato strategy, you’ll need to build your own portfolio with an online discount brokerage account, or find an advisor who advocates indexing.
How do I become a Couch Potato?
If you’ll be managing your portfolio yourself, start by opening an account with a discount brokerage, which will allow you to buy investments online. To learn about the major brokerages in Canada, see The Globe and Mail‘s annual online broker survey and read this review on the MoneySmarts blog.
Another option (especially for smaller portfolios) is to open an online investment account with TD Mutual Funds, which offers a family of low-fee index funds that are only available to its online customers.
If you’ll be parting ways with your advisor, tell him or her to sell all your current holdings—stocks, bonds, mutual funds—and transfer the cash to your new brokerage account. This will involve some paperwork and fees, and it may take a week or two. Your discount brokerage can help, and will often pay the transfer fee if you’re moving a large sum.
Should I use index mutual funds or ETFs?
The decision between index mutual funds and ETFs depends on several factors. Here are some rules of thumb.
Choose index mutual funds if:
- you’re investing less than $50,000
- you plan to make small, regular contributions
- you want to keep your portfolio simple, with just the basic asset classes
- you’re not comfortable buying and selling ETFs in a discount brokerage account
Choose ETFs if:
- you’re investing at least $50,000
- you plan to make infrequent, lump-sum contributions
- you want to include asset classes that are not available through index mutual funds (such as real estate, emerging markets, and real-return bonds)
- you’re comfortable using a discount brokerage to place trades
- you’re able to open a discount brokerage account with no annual fee, and that charges no more than $10 per trade
For more, see Comparing the Costs of Index Funds and ETFs.
Which funds or ETFs should I use in my portfolio?
See the Model Portfolios page for suggestions.