Investing: How I became a couch potato

Being a journalist has spin-off benefits. Problem is, most of them are of dubious value. Over the years I’ve managed to amass a modest library of free books. I’ve snagged trips to exotic locations— some of them with landmines. Once I even got a free rectal exam while doing a story on health clinics.

But this past spring, I finally scored a genuinely lucrative benefit. In fact, it’s one that may well turn out to be worth a couple of hundred thousand dollars. While working on the MoneySense Seven-Day Financial Makeover (see the October 2008 issue), I became a convert to index investing and moved all of my savings — including my RRSP and my children’s RESPs — into what MoneySense calls Couch Potato portfolios.

If you’re a regular reader of this magazine, you’re familiar with the Couch Potato strategy. It consists of investing in three to five low-cost index mutual funds or exchange-traded funds (ETFs). These index funds get their name because they’re designed to passively track — or index — major stock and bond markets. By keeping costs low and diversifying widely, you earn higher returns than investors who look for hot stocks and market-beating mutual funds.

I have been writing for MoneySense since 1999, so I’ve been hearing about the supposed superiority of Couch Potato investing for a long time. And yet, for reasons I’m about to explain, I was slow to embrace the notion of index investing — or passive investing, as it’s sometimes called, to distinguish it from funds that “actively” try to beat the market. Instead, I kept sending a few hundred bucks a month to a series of financial advisers, who used it to construct a portfolio of half a dozen actively managed mutual funds. I paid an annual fee to the investment firm, plus a less visible management fee of about 2.5% on the funds themselves. In other words, I did the same thing that tens of thousands of other Canadian investors do every month.

That changed during the Seven-Day Financial Makeover. I was supposed to be there as a reporter, but I ended up getting a makeover of my own. Not that it was an overnight, road-to-Damascus conversion: even after a week of listening to the experts crow about indexing, I was still skeptical and wanted to know more. I spent weeks reading about the theory and practice of indexing, studying the math and logic behind it. In the end, my initial reluctance evaporated and I’ve embraced index investing with an evangelical zeal.

Let’s take a walk through the common objections to index investing — the same ones that prevented me from realizing its merits for so many years.

If indexing is so great, why isn’t everyone doing it?

We’re taught to believe that if something sounds too good to be true, it probably is. That’s usually great advice, especially in investing, where get-rich-quick schemes are inevitably scams.

But indexing is not a get-rich-quick scheme. It doesn’t promise anything magical. I used to raise an eyebrow at the claim that simple, cheap index funds could beat the vast majority of professional money managers. It sounded like an extraordinary boast — 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 money managers fail at precisely what they’re paid to do, which is beat the market.

It’s not their fault: blame it on simple arithmetic. There are thousands of money managers out there and most of them are well trained and hard working. But you don’t need a PhD in math to know that the average manager, by definition, can’t beat the market average. Managers aren’t dumber than the market, they are the market. Expecting most of them to produce above-average results is a contradiction in terms — like expecting most kids in a school to have above-average grades.

Even if you are lucky enough to have your money with an above-average manager, that’s not the whole story. Money managers deduct hefty fees before they pass profits on to you. So while about half might beat the market average before fees, very few do so after subtracting their cut. That’s why simply buying the index — which guarantees you the market averages, minus tiny fees — consistently produces better results than most active managers.

The proof is in the numbers. Over any medium or long period, index investing wins. During the five years ending last September, about 89% of actively managed U.S. large cap funds lagged behind the S&P 500. In Canada, active investors did even worse. An astonishing 93% of Canadian equity funds failed to keep up with the S&P/TSX composite index. To make matters even more discouraging for active investors, the tiny fraction of funds that do better than the index each year are constantly changing. No one consistently finishes ahead of the pack.

So why doesn’t everyone index? I think it’s human nature. Just because a strategy is simple and proven to work doesn’t mean that people will adopt it. We all know a simple, proven way to lose weight: eat less and exercise more. Yet every year, we spend billions on useless weight loss products.

My mutual funds charge only 2.5% a year in fees. That’s not much considering that my money is being managed by highly skilled professionals.

Few things in life are free. We don’t expect our electrician to work for nothing, so it makes perfect sense to pay 2.5% to the professionals who manage our life savings, right?

I used to think so. But now I understand that these fees, when compounded over years, can cost you tens of thousands — even hundreds of thousands — of dollars.

First off, it’s important to note that indexing, while far cheaper than active investing, is not free. Because the holdings in an index fund are determined by passively tracking a benchmark, a computer makes the big decisions. Since computers don’t drive BMWs, index funds typically charge just 0.5% or less in management fees, compared with the 2.5% that many mutual funds charge.

What effect does a measly two percentage points have? The stark reality hit me square in the face during the Seven-Day Financial Makeover, when one of the experts showed us a graph that illustrated the difference between a portfolio with a net return of 7% a year and a portfolio with a net return of 5% because of fees.

In the former case, where you’re getting the full 7% return, $2,500 invested annually for 35 years will swell to more than $345,000. But at 5%, your nest egg would grow to less than $226,000. That’s right: a 2% fee can cost you almost a third of your potential gains. The low-fee investor in this example will wind up with enough extra money to quit work five-and-a-half years earlier than the high-fee investor. Make no mistake: fees make an enormous difference.

Paying tens of thousands in fees would be one thing if you were getting value for that money. But that value is there only in special cases. I think it makes perfect sense to hire a financial planner (preferably a fee-only one) if you have zero investment knowledge and are just getting started. Ditto if you’re prone to impetuous financial decisions and need someone to restrain you, or if you require highly technical advice about estate planning or insurance.

But if you’re paying someone simply to choose stocks or mutual funds for you — as I did for more than a decade — you are paying a huge amount of money for something you can do yourself with minimal effort simply by buying an index fund. Hiring a financial adviser to pick stocks or funds is like hiring an electrician to screw in a light bulb — and then paying him extra fees, year after year, for the light it produces.

My investment adviser has beat the market three years in a row, even after fees. She obviously knows what she’s doing.

Actually, she’s just lucky. I know this is tough to hear. Your investment adviser has certificates hanging in her office, testifying to her training. She sounds smart when she talks about giving you exposure to this market and that sector. But as one financial author puts it, “Wall Street’s favorite scam is pretending that luck is skill.”

Here’s a beautiful illustration of the point. Assume you’re tossing coins, and if you flip heads, you earn $1,000, while flipping tails means you lose $1,000. When 10,000 people engage in this little exercise, an average of 5,000 of them will be winners after one toss. After two flips, 2,500 will have flipped heads both times. After 10 flips, about 10 of our flippers will be enjoying an incredible winning streak purely by chance. Things work the same way in investing. Purely by chance, many managers and advisers will put together long streaks of beating the market. That is no guarantee the streak will continue.

If you are an index investor, you are guaranteed to never beat the market after fees. Why choose an investment strategy that will forever produce mediocre returns?

It is true that an index fund cannot beat the market it’s tracking. It must, by design, produce average market returns. And once you subtract the small fee, your net return drops slightly below the market average. If you have an index fund that tracks the S&P 500 and carries a 0.5% fee, you are guaranteed to trail the market by half a percentage point every year.

That sounds ugly until you consider the alternative. With an actively managed fund that carries a management fee of 2.5%, you would have to beat the market by an average of 2% every year to match the performance of the index fund after costs. Some years you may accomplish that. But over the long term, the feat is extremely unlikely, and the vast majority of funds fail to do so.

When people argue that index funds are doomed to deliver below-average returns, they are playing games with what “average” refers to. In this case, it refers to the overall market average, not the average return of comparable mutual funds. As we’ve seen, most active funds produce returns that are below market averages. So while it’s true that index funds will produce returns that are a hair below the market average, they will still do better than the average actively managed fund.

If you are considering buying an index fund that tracks the S&P 500, compare its long-term performance to actively managed funds that invest in U.S. large cap stocks. Over any significant time period, the index fund will beat the majority of these funds. In many cases the index fund will rank in the top 25%. In other words, there is nothing “average” or “mediocre” about index funds when compared with the alternatives.

My investment adviser is a friend. I know it’s silly but I feel bad about firing her.

OK, you like your adviser personally. She’s a neighbor, and your kids go to school together. I hear you. But that doesn’t mean you should pay thousands of dollars for services you don’t need. I have a friend who’s a plumber, but I don’t hire him to flush the toilet for me.

If you have a stockbroker, tell him the coin-flipping story before you fire him. Just don’t expect him to have a revelation about the power of randomness. As Upton Sinclair wrote: “It is difficult to get a man to understand something when his salary depends upon his not understanding it.”

Index investing is fundamentally conservative. I want to invest aggressively, so it doesn’t make sense for me.

There is nothing fundamentally conservative about index investing. Whether you are a 65-year-old retiree who wants to preserve capital or a 21-year-old who’s willing to take on big risks, the power of indexing works equally well.

This is because the key factor that determines the risk level of your portfolio is not the individual securities that you buy. Far more important is asset allocation: the relative mix of stocks and bonds. A middle-aged investor who plans to retire in 25 years might reasonably choose a portfolio of 60% stocks, 40% bonds. A younger person might do better with 70% stocks and fewer bonds, while a retiree will sleep much easier with a portfolio of 70% or even 80% bonds.

You can easily achieve any of these asset allocations using index funds. An investor with a 25-year horizon might build a portfolio with index funds tracking U.S. stocks (20%), Canadianstocks (20%), international stocks (20%) and the Canadian bond market (40%). Using these same four funds, a different investor can easily turn this portfolio into a fiendishly aggressive or sleepily conservative one, simply by changing the weighting. Want more risk? Put just 25% in the bond fund and add another 5% to each of the equity funds. Need more security? Do the opposite.

There is a perverse myth that index investing is an unsophisticated, one-size-fits-all strategy that is unsuited to people who really understand finance. This is a lie. Index investing is endorsed by the world’s top economists and finance professors, many with Nobel Prizes on their mantels, and all of whom know more math than your broker. Institutional investors, such as endowment funds and pension funds, also embrace indexing. These funds have billions of dollars in assets and could afford to hire the best active managers in the world, but they choose not to. By now you understand why.

OK, Mr. Potato Head, how did you make out during the crash of 2008?

I switched to an index strategy last August, and by late December I was down 20% overall, including losing a third of my equity positions. I went from Couch Potato to mashed potato. But these losses had nothing to do with flaws in the indexing strategy. I would have done just as badly or worse with my active investments — and paid someone a fee for losing my money.

Almost all investors lose money when markets fall, and that includes Couch Potatoes. But over the course of a bear market, the average investor in actively managed funds will do worse than the indexer. Want proof? During the bear market of August 2000 to December 2002, only 39% of active Canadian equity funds outperformed the S&P/TSX composite index, and only 29% of U.S. equity funds did better than the S&P 500. Couch Potatoes still lost money, but they lost less. No one knows how long the current bear market will last, but when it’s over, it’s likely that indexers who stayed the course will be better off.

You will often hear people say that indexing works only in bull markets. These people argue that when times are tough — and they are downright brutal now — you need an active manager to protect you by ditching your worst performers and then reinvesting when the markets pick up.

The best response to this line of argument is to note that active managers can protect you only if they guess right. To do so, they have tomove into cash before the market hits bottom, and then reinvest when it’s on its way back up. The problem with this is that active managers have no way of knowing where the bottom of the market is, nor when stocks will head back up. So to succeed, they need to guess right twice: first when they sell; again when they buy. For the record, your probability of being right on two coin flips is one in four — the same as your chances of being wrong both times. The commissions are the same either way.

Indexing is not a magic formula. It doesn’t guarantee you anything except a fair share of market returns — which sometimes means loss — for a very low cost. If that doesn’t sound like a fair deal, ask your financial adviser whether she can promise you the same.