Your Complete Guide to Index Investing with Dan Bortolotti

Does This Thing Work?

2018-06-17T20:00:55+00:00July 29th, 2010|Categories: Behavioral Finance, Indexing Basics|21 Comments

This week I received an email from a reader of MoneySense magazine, where I write regularly about the Couch Potato strategy. Kate was concerned that index investing wasn’t delivering on its promises. With her her permission, I’d like to share her email and my response to her concerns, which I’m sure others share.

It’s important for new index investors to understand that the strategy guarantees simplicity and low fees, but it’s still at the mercy of Mr. Market. It’s also another reminder that ETFs may not be appropriate for small portfolios.

Dear Dan,

I have a financial advisor who oversees my investments. I was shocked to read in your articles about how much commissions and fees add up over the years. I am not financially savvy and have left it up to my advisor to deal with my investments, and I have been disappointed in how little they have grown.

Then I read an article about the Couch Potato strategy in the February/March 2007 issue of MoneySense and wanted to give it a try.  I took $10,000 and invested it in the High-Growth Couch Potato portfolio. I invested 25% in each of the following:

iShares &P/TSX Capped Composite (XIC)
iShares S&P 500 CAD-hedged (XSP)
iShares MSCI EAFE CAD-hedged (XIN)
iShares DEX Universe Bond (XBB)

As indicated in the article, I have rebalanced once a year, but I am finding that I have not made any gains. My $10,000 is now at $9,058.20. I had read that gains were steady with the Couch Potato strategy but do not see that with my portfolio.

So, my question to you is, am I in the right investments? Do I just need to wait it out longer and keep rebalancing each year? Do I need more than $10,000 in the portfolio to make it worthwhile?

It’s hard to blame Kate for her frustration. The article she refers to included stats that showed the Classic Couch Potato portfolio would have had an annualized returns of 11.8% from 1976 through 2006. Here’s how I answered:

Dear Kate,

I’m sorry to hear that you have had a negative experience with the Couch Potato strategy.

It’s important to understand how the strategy works and what it is designed to do. You write that “I had read that gains were steady with the Couch Potato strategy,” but this is not something we would have ever written in MoneySense, because it’s not true. The only investments that provide steady gains are savings accounts and GICs.

The Couch Potato strategy is designed to deliver the same returns as the overall stock and bond markets, minus very small costs. Index funds and ETFs offer no protection from a falling market. The only thing they promise is that your gains or losses will not be significantly different from the indexes, and that you won’t be losing 2% or more each year in fees. The funds your advisor uses will sometimes lose less or gain more than the indexes. But over the long term this is unlikely to continue, because the drag caused by fees is relentless.

You mentioned that you got started with the Couch Potato strategy in mid-2007. Through no fault of your own, this turned out to be terrible timing. Stocks markets around the world saw huge gains between 2003 and 2006, and mid-2007 was the peak of that long bull market. So you had the bad luck of buying when prices were highest. Things immediately got worse in the second half of 2007, and then 2008-09 saw the worst crash since the Great Depression.

Just about everyone who had money in the markets—and your portfolio was 75% stocks—lost money during this period. The Canadian, US and international markets are still lower than they were in 2007, so the ETFs that track them are down, too.

You also asked whether you need more than $10,000 in the portfolio to make it worthwhile. In some ways, the answer is yes. Using ETFs and rebalancing once a year is inefficient with small accounts. Many discount brokerages charge $29 per trade, so the cost of rebalancing is about $116, or 1.16% annually on a $10,000 portfolio. Of the $950 you have lost in your portfolio, more than a third would have been from brokerage commissions if you have done three rebalances (12 trades at $29 = $348).

If you decide to stick with ETFs, you might consider rebalancing only every two years (or even less) to reduce the costs. But you may even want to think about index mutual funds instead. These two articles offer detailed suggestions for using the Couch Potato strategy in a small portfolio:

Become a Couch Potato Investor With Less Than $5,000

Should You Use Index Funds or ETFs?