Sometimes I wonder why everyone isn’t getting better returns than a simple Couch Potato portfolio. Spend a little time and you’ll discover all kinds of strategies that beat the market. And I’m not talking about the nutbars who promise 5400% gains on penny stocks—no one takes those seriously. I mean reasonable strategies that have been studied by academics—or at least serious practitioners.
Really, why would anyone use cap-weighted index funds when equal-weighted indexes, fundamental indexes and value-weighted indexes all crush them over the long run? And why buy the whole market instead of zeroing in on small-cap stocks, value stocks, and low-beta stocks, all of which have outperformed the broad indexes?
Why stay invested at all times when you can reduce your risk and earn higher returns by market timing with technical analysis, or even with a less fussy technique like “sell in May and go away.”
If you want to keep your volatility low and still pull in 9% a year, just put half your money in gold and cash with The Permanent Portfolio, which had just two negative years in the last 40.
Better still, pick the individual stocks that will deliver better risk-adjusted returns. Screening for high-yield had a great run in the US and also worked in Canada, China and Finland. Or just pick companies with a history of raising their dividends. Heck, even common sense works: just pick companies in essential industries.
If you want a colourful graph showing how these strategies kick traditional indexing to the curb, I can help you find one.
Of course, this leads to an important question: If there are at least a dozen simple ways to beat the market, how come so few investors are actually getting these returns? Obviously the costs and taxes involved in implementing these backtested strategies are a huge part of the problem—in fact, they’re enough to immediately render most of them useless. But let’s ignore that for argument’s sake. I suggest an equally large problem is the very mindset of the active investor.
Will you hold on when it’s not working?
By definition, active investors expect to beat the market. Most acknowledge they can never do this over every period, but their behaviour suggests they don’t have a lot of patience with underperformance of even two or three years. And there’s the rub: even if you accept there are legitimate market-beating strategies, all of them will see multi-year periods when they will lag. Even small-cap and value stocks—which have delivered higher risk-adjusted returns over many decades—have endured prolonged stretches of dramatic underperformance. Some active investors have been rewarded for sticking to their strategy during rough stretches, but they are exceedingly rare.
Index investors are not immune to impatience, of course, and many have bailed on the strategy during periods of market turmoil. But I would argue the experienced ones have expectations that are quite different form those of the active investor. We know that when the markets go down 20%, we’re going to lose 20%—but never significantly more. When that happens, we don’t complain that the strategy is breaking down. Because delivering the same return as the market is exactly what indexing is supposed to do.
On the other hand, if beating the market is your primary goal, you’ll frequently wonder whether your strategy is working. In a year when markets are up 10% and you’re down 3%, you’re likely to be frustrated, even furious. When it happens three or four years in a row—and it will with even the best active strategies—most investors will have already switched to something else. Talk to a few advisors or look at mutual fund inflows and outflows if you don’t believe me.
I like to remind investors that the Couch Potato strategy isn’t just about low cost and broad diversification. It’s about accepting that the markets give what they give, and the best we can do is capture as much of that as possible. That means accepting that over any period of three, or five, or even 10 years, there will always be investments that would have done better. But there won’t be a lot of investors who can make the same claim.
In looking back at the Permanent Portfolio (and admittedly you may have covered this previously), what is the best way to hold the bullion portion?
@Ken: If you’re going to do this, a fund like the iShares Gold Trust (listed on the TSX as IGT) is easiest and cheapest.
https://canadiancouchpotato.com/2011/07/25/ask-the-spud-ishares-gold-trust/
My conclusion from this blog entry would be that few people seem to have the intestinal fortitude to stick to an active-type strategy when things aren’t going their way, in part because you have to wonder whether your strategy is sound or not (and it’s a legit question, given that any winning strategy would effect the market and the efficient market hypothesis would mean the strategy would stop working), whereas a pure couch potato approach is guaranteed to give you close to market returns (on a risk-ajusted basis).
Is that the Coles-Notes version or am I missing anything ? (other than the tax element you chose not to examine)
@Paul G: That’s pretty much it. You may want to look at this document, which is also linked in the post:
http://www.rwbaird.com/bolimages/Media/PDF/Whitepapers/Truth-About-Top-Performing-Money-Managers.pdf
The paper argues that even fund managers with excellent long-term records experienced significant periods of underperformance. But active investors don’t usually have the patience to wait these out, so they don’t get the benefit of the outperformance. They’re like the driver in the traffic jam who keeps changing lanes so he feels like he’s doing something. In the end, he probably would have got to his destination faster is he had just stayed put.
I was looking at the 1,5,10 returns of Mawer’s balanced fund. Mawer has outperformed the TD e-series over all the periods. So there are managers doing a pretty god job.
@Stuart: I would not argue strongly with any investor who wanted to use the Mawer fund, which is globally diversified, cheap, and prudently run. (I would point out, though, that much of its outperformance versus the Global Couch Potato is a result of its higher strategic allocation to Canadian stocks, which beat US and international over that 10-year period.) Actually, I think a low-cost balanced fund is great for encouraging good behavior. There is some evidence from Vanguard that investors in balanced funds are less likely to move money in an out with market conditions.
CP wrote “@Ken: If you’re going to do this…”
Actually for a start I will create a 100k dummy portfolio on GoogleMoney. That way I can watch it for a while. I do this in order to do comparison tracking of various approaches against each other and again my real portfolio.
Thanks and keep up the great writing.
@Ken: My post was actually trying to convince people to avoid what you’re suggesting. Because what’s going to happen is that you will test-drive various strategies, and they will each take turns outperforming and lagging. Then what will you do? Chances are good you’ll start moving from one to the other, always a step or two behind.
Even if you don’t keep changing strategies, at least one of the alternatives is bound to be outperforming your own portfolio, and you’ll be constantly playing “should, woulda, coulda.” Isn’t better to choose one sensible strategy and make peace with it?
CCP, with all due respect, you’ve presented what most EMH proponents have for a very long-time. For whatever reason, passive investors seem to throw up strategies based on allocation and nothing more, forgetting that the stock market is a place to buy and sell parts of businesses.
Some people can and do pick better businesses than others over the long-haul. I’m not sure what makes that so challenging that is has to be almost impossible.
I know a few friends who have done well with all of their money in 4 to 6 “Monthly income funds” (the cheaper ones, RBC etc) and have done fairly well. Their monthly money is re invested automatically. A balanced approach is never wrong, in my estimation, but you want to keep the fees low.
@Michel: I think it’s important to separate “doing well” from beating the market. Most of the banks’ monthly income funds are about 50% bonds and 50% Canadian dividend stocks, two asset classes that have been among the best over the last 10 years. But over the the long term, I think you will find that most of these funds will deliver returns very similar to a portfolio of 50% XBB and 50% XDV. There often isn’t any significant alpha.
But as with the Mawer fund that Stuart mentioned above, it’s hard to criticize a prudent, low-turnover balanced fund with a fee of 1% or so. Investors who use these funds tend to be quite disciplined and aren’t likely to jump around looking for the next hot strategy.
JT, The reason passive investors only “throw up” strategies based on allocation is because there isn’t much else to talk about, otherwise they wouldn’t be “passive” investors. :)
The strategy of the passive investor is to index, diversify to lower risk, and re-balance regularly. There’s not much else to it, and that’s really the point.
@JT: Passive investing strategies are based on about 50 years of rigorous academic research that has demonstrated that “picking better businesses” is not nearly as straightforward as it sounds. If it were, the record of active investors would not be so dismal.
It’s not “almost impossible” to beat the market significantly over the long term, but it is so unlikely that it should not be an investor’s primary goal. Of course some people do better than others, and there are many who have enjoyed extraordinary success. But for every one of these there a thousand failures no one ever hears about.
The distinction between active and passive investing as it relates to alternative index construction methodologies is, with the greatest of respect, vacuous. Cap-weighted indexes are based on their own “strategy”, which is to focus on price rather than, say, dividends or value or size factors. Ironically, this makes gives them a momentum bias, because the weighting of a company increases in the index as its price rises.
As investors we now have the opportunity to choose among a number of rules-based indexes, of which a cap-weighted index is one example. The fact that it constitutes “the market” is wholly irrelevant. Our objective is to generate reasonable returns with acceptable risk and at the lowest cost possible. If the back-testing (which you implicitly denigrate except as it relates to your preferred index) on cap-weighted indexes indicated that we are unlikely to achieve our investment objective investing in them, it would be irrational to invest in them just because they represent the market.
The point is that there are a wide variety of indexes to choose from. We should make our selection based on our investment objectives and our assessment of the relevant data and costs. Each and every one of them, however, represents a strategy, has been back-tested and is active in the sense that it makes changes periodically in response to market changes.
Frankly, I think the importance of personality is lost in the sort of quantitive analysis that customarily dominates choices of these sorts. If the objective is to pick a strategy that you’ll be able to stick with even when it’s not working, far better to pick one that suits your personality. For instance, if you’re the sort of person who is contrarian in life, you’re likely to do better with a value index. Others, are able to stick it out on the thought that “I’m being paid to wait”, which argues perhaps for allocations to dividend indexes and high yield bonds.
Finally, you assume that the objective of strategies you’ve described as “active” is to beat the market. I’m not sure that assumption is sound. I, for instance, seek out alternative strategies because they suit my personality better (I’m contrarian), because I’m able to sleep better with some of them, specifically a collection of them. If diversification of asset classes makes sense, then it seems to me that in principle diversification among strategies also makes sense. We cannot know which strategy will perform the best on a risk-adjusted basis in the future, as you point out. That argues for diversifying among strategies rather than selecting one just because it’s “the market”.
@Drew: Thanks for the comments. The distinction between cap-weighted indexes and alternative indexes is not considered vacuous among academics or practitioners. Any investment strategy needs to be compared against a benchmark, and a cap-weighted total-market index is the most sensible baseline. You may not agree that cap-weighting is also the best investment strategy (and you might be correct), but it is still the right benchmark because it imposes the fewest number of rules, and is easily investable at extremely low cost.
I don’t entirely denigrate backtesting—it can be useful. I just like to remind investors that investors almost never get the returns of backtested active strategies (including alternative index strategies), since costs are often ignored. Passive strategies (especially involving cap-weighted indexes) are not perfect, but they are without question the easiest to replicate because of their extremely low cost and low turnover.
RE: “If diversification of asset classes makes sense, then it seems to me that in principle diversification among strategies also makes sense.” I would disagree with that on purely mathematical grounds. When you place a bet with a negative expected value (whether it’s active management or a hand of blackjack), you don’t increase your odds by playing more.
Using, say, three different active strategies makes it more likely you will hold one of the winners in part of your portfolio, but it must also make it more likely that your overall portfolio will underperform.
Just to clarify, I don’t regard the distinction between cap-weighted and alternative indexes to be vacuous, rather the fact that you label all of the latter as being active and only cap-weighted as passive. My point is that alternative indexes are fundamentally forms of indexing, and your language implies they are much more like active management. Your language muddies the distinction between alternative indexing and active management, two very different beasts. It also implies that cap-weighted indexes are fundamentally different from alternative indexes, when in fact they differ only in degree, not kind.
Regarding benchmarks, your post did not appear to me about benchmarking but about the best investing strategy. Frankly, investment professional may care about benchmarking, but I don’t, as I said, care about “beating” the market. My point was that there are reasons for choosing alternatives other than to beat the market. You seem to assume that the only reason to choose them is so as to beat the market.
Ironically, after over a decade of material under-performance, my instinct is that cap-weighting might well out-perform many of the alternative indexes in the future. My instinct in 1999 was, thankfully, precisely the opposite. My point, however, is not to predict what will be the best strategy in the future – I really don’t know – but rather to say that no one strategy is right at all times, in all places and for all people, with one exception – control what you can be minimizing taxes and costs, but not at the expense of suffering material losses by investing on the basis of cost alone.
Your point about diversification baffles me. I might not be very bright, but I do my best not to invest in assets or strategies having a negative expected value. The point I tried to make is that you might invest in, by example, value and relative strength on the equity side – all with positive expected returns, but not in the same time sequences – and perhaps a risk parity overlay for the whole portfolio. Some perform well at one time, others at another, smoothing returns over time just as allocations to non-equity, un-correlated asset classes are designed to do.
But the irony of your point seems to be that you believe you can predict returns – how else could you conclude the expected returns are negative – and that you should act on this prediction. You should, your argument implies, avoid investing in a strategy or asset class with negative expected returns. But your argument in the blog seems to be that you should blindly invest in a cap-weighted index regardless of what you expect the returns to be. This strikes me as a logical inconsistency. (I see the same sort of inconsistency with Vanguard’s recent paper attacking alternative indexes on the basis that the sole relevant criteria should be price, and then they hedge the CDN for their recent US index ETFs, contradicting their own argument that we should accept the price the market gives us for everything, CDN presumably included.)
What’s equally surprising about your comment is that it implies that if I expect the returns on my bond allocation to be negative I should sell them all. Yet we probably both agree that we hold bonds because we cannot predict returns accurately and as a hedge against our beliefs proving to be wrong.
I’ll conclude by saying that I agree that there is no point in trying to beat the market. But it does not follow from that agreement that the market, understood as a cap-weighted index, makes the most sense for me, just as it does not make sense, as you recently pointed out, to invest in the world-wide market in proportions equal to the component countries in that market. Our disagreement centers on the fact that you went beyond saying that it makes no sense to beat the market. You argued, in effect, that alternative indexes are the equivalent of active management and just as foolish. I agree with your judgement of active management, but not your depiction of the fundamental nature of alternative indexes.
Notice that the CPP Uber-Tuber portfolio includes plenty of non-cap-weighted indexes (e.g., PDN, PRF, CRQ). These aren’t “actively” manged and I don’t think this post is saying they all.
@Drew: I’ll just clarify two points and leave it at that.
1. Alternative indexes fall somewhere between active and passive management, according to the traditional definitions of those terms. Clearly there is a difference between a quantitative screen (such as that used by fundamental indexes) and a human manager picking stocks, and I completely agree that the former is preferable. I’m agnostic about alternative indexes. (As Stephen D had pointed out, I include some of them in one of my model portfolios for investors who want a value tilt.) I would not argue strongly with anyone who used them. My point in this post is that it sometimes seems like every alternative index has beaten cap-weighting in backtests, yet I’m not convinced there are a lot of investors who are actually getting those returns, for reasons of both cost and behaviour.
2. I did not say that active strategies had negative expected returns. I said they had negative expected value , though perhaps I should have said negative alpha. In other words, they are more likely to lag the market than to beat it. If the probability of an active strategy beating the market is 40% (I’m being generous), and you invest using five strategies, then two are likely to outperform and three are likely to trail. In order for the overall portfolio to outperform, the two winners would have to add more alpha than the three losers subtract. That is not likely.
Ironically, the more strategies you combine, the more your overall performance begins to resemble an index fund.
Finding backtested strategies that have beaten the market can be a lot fun. But Dan is right that many of those strategies disappoint investors going forward, and if they don’t work out for a short period of time (I consider ten years a very short period of time) then people abandon the strategy.
Picking a strategy and then “watching it to see how it does against other strategies” unfortunately, isn’t productive, as Dan mentioned. It will take at least 30 years before you know that a strategy worked out for you. Short term results don’t mean much at all.
I have enjoyed writing about alternative strategies. I wrote one for the current issue of Canadian Business.
But despite the multiple backtested methods out there, nobody I’ve met (with a 15-20 year track record) has beaten the couch potato with real money. I know that the couch potato isn’t perfect, but it would be fascinating to know what percentage of investors have lost to this strategy over the past 15-20 years.
I would guess that 99% have fallen short. Maybe more! Investors behave poorly. According to Barrons, the average U.S. mutual fund made 8.4% annually from 1988 to 2008, but the average American investor made just 1.8%. Many of those folks were “sophisticated sorts” perpetually looking for the next edge. And their adventurousness killed their returns. You may find (and this is just a guess) that 10% of active balanced funds have beaten the couch potato over the past 15 years, but investors in those funds will have vastly underperformed the funds they own, for the reason Dan mentions: they don’t stick with them during tough times.
I believe that very few investors will have the emotional fortitude to stick to the couch potato for their investment lifetimes. But those who do will likely perform well–especially compared to those who are constantly on the look-out for new strategies.
For kicks, check out the Assetbuilder site of “improved” couch potato portfolio platforms. Backtested studies have suggested that you could do better than the couch potato. And Assetbuilder (neither confirming nor denying this claim) has been tracking a series of couch potato alternatives along with the original couch potato portfolio that Scott Burns created back in 1991. Despite all of the “improved models” having better back-tested results, check to see which fund has had the best performance since 2007–the simple couch potato: http://assetbuilder.com/couch_potato/couch_potato_results.aspx
If you have beaten the Canadian Couch potato over the past 15 years, speak up. I am curious, of course.
@Andrew: Thanks as always for your insight. It’s funny that you say you consider 10 years to be a very short time—you’re right, of course, though in talking to advisors I’ve learned that most investors’ patience lasts no more than three or four years. Then they start saying “this doesn’t work, let’s try something else.”
I’ve always been a bit confused about why people try different strategies for short periods to “see how they do.” We’ve just come through a period where savings accounts beat stocks for 10 years. What information would you have gained from that? That sitting in cash is “working well” and you should keep doing it? This is what Larry Swedroe calls confusing a good strategy with a good outcome.
As you’ve pointed out, it’s not that alternatives to passive strategies are inherently bad, or that the Couch Potato is perfect. It’s that it is too easy to get preoccupied with the search for something better, and that can lead to a cycle of trying something new, feeling disappointed, tying something else, feeling disappointed, and so on.
I had not seen the Asset Builder comparison of the basic Couch Potato with the other more complicated portfolios. There must be something specific driving its outperformance: more bonds than all of the others, perhaps?
The Asset Builder “Couch Potato” portfolio has outperformed because it only has bonds and US stocks. Is this even a rational Couch Potato portfolio? The equity side of the portfolio is essentially an active bet that 62% of the broad stock market capitalization is not efficiently priced and not worth investing in. I don’t really think outperformance of this type of portfolio supports Andrew’s position at all.
@Chris: You’re right, of course, that the performance over the last five years is meaningless. And I would never recommend the two-fund Couch Potato anymore, when it is easy to get much broader diversification at low cost. (This simple version was created more than 20 years when there were very few options.)
But I think Andrew’s main point was that, as dead simple as this two-fund portfolio was, there are probably very few investors whose personal rates of return were better of that 20 years.
The cost to implement the strategy can be a large drag on returns in a low return environment. An advisor that charges 130 basis points above an index strategy that ultimately has only index returns can reduce a real compound annual return of 4.3% by at least 50% over 20 years and at least 100% over 30 years.
This is one reason why the hedge fund compensation model is being challenged.
If you are using a mutual fund for the strategy it is likely you will have such a drag. Likewise a 1.65% fee only advisor – who is effectively charging 130 basis points to manage the stock portion of a 50/50 portfolio.
Regardless of strategy its an important first principal to ask what are the potentials of good or bad outcomes by straying from the risk free return over the short and long run. Any equity correlated strategy must be recognized to have higher risk of bad outcomes over shorter time horizons and even the potential for mediocre outcomes over long horizons.
Hey Andrew, the numbers for retail investors can get even worse. I’ve read that investors in Lynch’s Magellan fund had returns of about 1% on average, while the most famous fund of all time was averaging near 20% annually for an extended period. Essentially, losing considerably against inflation while the fund that they frequented had the best returns in history.
It’s certainly all about psychology in explaining that terrible and sad record.
That said, investors are best served matching their portfolio mix to their risk threshold. That should be THE number on goal – selecting a portfolio and strategy that you can stick with, through thick and thin.
I would guess that even the classic 60% equities to 40% bonds is still too volatile for most investors. Through severe equity corrections those portfolios are going to experience 25% declines (or more). Most can’t take that sight.
I sold a large percentage of my equity holdings near the top(s) and now sit in a range of 60-75% bonds in my three accounts. Even my account with the lowly 60% has only fallen only fallen 2% from its recent all time highs – over the last few years. That’s ‘volatility’ that any investor can handle.
And given that, I am much more comfortable adding more risk as the markets collapse. In fact, I am on the other side of the fence hoping for a very severe correction. In predetermined stages (of market declines) I will reallocate to 50-60% equities. I will at that point be purchasing considerable income from equity etf’s, and be done, other than managing the reinvestment of bond and equity income.
And lastly on beating the markets, I will share my luck on that topic. While I would prefer to be in a Canadian equity etf such as xiu, i have been unable to liquidate my four major Canadian equity holdings as they have beat the tsx by a considerable amount.
Chart THI, ENB, TRP and CPG against the tsx over five years or more and you will see my ‘problem’. Over a five-year period, I have gains of 120% 100% 60% and 20% plus healthy dividends – all while the tsx 60 lost 20%.
Full disclosure – I lost all on a very small position on Oilexco along the way.
I certainly cannot liquidate those stocks and purchase the market, yet. Even though I have to admit that it was lucky to be in defensive positions that did so well. And that was a macro call or guess. To sell those positions would the inverse definition of insanity – to go against what is working.
@Dale: Thanks for sharing your experience. I’m not clear why you’ve said you “certainly cannot liquidate those stocks and purchase the market.” Are you worried about incurring a huge tax hit, or are you just reluctant to sell your winners because you think they will continue to outperform over the next five years, as they have over the previous five?
Also, just to clarify, while your four stocks have clearly clobbered the market, XIU is nowhere close to being down 20% over the last five years: it’s barely down at all. It’s highly misleading to look at the the price-only index rather than an ETF tracking that index.
No tax hit, they’re in my rrsp account. And for sure there are some divvy’s to offset the 20% price decline. Throw in divvy’s and I beat the market by even more.
And yes, it makes no sense to sell ’em – they work until they don’t. Moving forward I’m looking to add the xiu and some more dow30, and xei for Canadian Dividends. I also have some Canadian reit and equity exposure through the multi asset xtr.