Better Personal Investing

Standard

“The index fund is a good innovation, not because it has any magic – anone can figure it out – but simply because by owning the market at a very low cost you will, by definition, do better than everyone who owns the market at a very high cost” – John Bogle

I think by now we’ve all heard some stats on the poor long-term performance of actively managed funds.  From mid-2004 to mid-2009:

  • S&P 500 outperformed 63% of managed large-cap funds
  • S&P Mid-Cap 400 outperformed 73.5% of managed mid-cap funds
  • S&P Small-Cap 600 outperformed 67.7% of managed small-cap funds

Of course anomalies exist!  I’ve seen hedge fund prospectuses (prospecti?) with years that enjoyed gains in the hundreds of percents.  On a more reasonable basis, we see active funds that will outperform the market for five years at a time.  But this doesn’t mean that they have any “secret sauce” or expert opinion that can be applied consistently to win.  In fact, since there must be thousands of managed funds right now in North America, and tens if not hundreds of thousands of asset managers, there’s no way that any of them are able to consistently beat the others.

And you never know which fund will be outperforming in which year.

You need to avoid two things:

1) Wasting your time trying to identify mutual funds that will do well – the research and uncertainty involved is annoying and most people are unqualified (myself included)

2) Decreasing your returns by paying significant management fees.  The funds that my bank account manager recommend all have expense ratios between 1.4% and 2.25% annually.  That comes right off the top of your returns.  This sounds small but has a big effect: If we invested $100k for 20 years, 5% will result in $265k, and 7% will result in $386k.  That’s a big difference.

How do we avoid these?  Follow the warning in the quote at the top – try to match the market at the lowest possible cost.  We do that with ETFs, which have expense ratios more like 0.25%.  You just boosted your returns by over 1% annually compounded.  That’s huge.

I love the Couch Potato Portfolio.  Individuals can follow it with minimal investment knowledge and minimal time investment and produce market-tracking returns that will beat most managed funds over any time period over say five years. (Intro here, but most of it is covered in this post).

You buy a group of only 3-5 ETF funds in your cheap discount brokerage account, and you rebalance twice a year.  Rebalancing is when you sell the ones that have gone up and buy the ones that have gone down, so they go back to being evenly distributed.  This GUARANTEES that you are buying low and selling high :)

Here’s an example, using $100k in the “High-Growth Couch Potato”, which I use since I’m young-ish and can have a higher exposure to stocks.  There are a few options on the Canadian Business site for ways to tailor the program to your investing style / goals: Meet the Potato Family.

Initially, I buy:

  • 25% Canadian Equity (iShares XIC, MER 0.25%)
  • 25% US Equity (iShares XSP, MER 0.24%)
  • 25% International Equity (iShares XIN, MER 0.5%)
  • 25% Canadian Bonds (iShares XBB, MER 0.30%)

Your total expense ratio is 0.32%, compared to the 1.5-2% for managed funds.

Spend an hour or two every six months rebalancing.  Say our Canadian and US Equity funds have gone up and the rest are flat or down, I sell those two to bring them to 25% of the new total value and spread the proceeds to the other three in amounts that bring them up to 25% as well.

Read more about the process at the Canadian Business website, which goes into detail on the rationale, the process and the variations:

Introduction

Do the Couch Potato: Step by step guide

Building blocks: ETF suggestions