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.”
“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.