9% Couch Potato returns won’t last

One way to bring some perspective to your investments is to go back and read financial articles from a few years ago. I thought about this recently as I calculated the returns of the Global Couch Potato since 2009. This simple balanced portfolio includes 40% bonds and 60% stocks (with equal parts Canada, U.S. and international) and you can build it with index mutual funds or ETFs. The version using TD e-Series funds enjoyed a return of 9.1% annually during the six years ending in 2014, which turned a $1,000 investment into $1,687. Pretty impressive numbers, and enough to make indexers out of many former stock pickers and other active investors.

But flip through some back issues of MoneySense and you’ll read a different tale. In one of my first Index Investor columns back in June 2011, I found myself on the defensive. The e-Series funds had recently celebrated their 10th anniversary, and let’s just say the numbers were discouraging: the Global Couch Potato returned just under 4% annually during the decade ending in 2010. That dismal result made a lot of investors wonder whether indexing made any sense at all.

So which assessment is correct? Is the Couch Potato strategy a path to stellar returns or stinging disappointment? The truth is, it’s a bit of both. And if you’re a recent convert to index investing, you need to understand that. The Couch Potato strategy works over the long haul because it’s based on broad diversification, low cost, and strict discipline. But along the way there will be giddy highs and vomit-inducing lows.

The party can’t last forever

If you became a Couch Potato during the last few years you’re probably feeling pretty proud of yourself. Not only has your portfolio enjoyed double-digit returns since 2012, but it’s done so with little volatility. Sure, last autumn was difficult for Canadian stocks, and bonds hit a rough patch in 2013. But markets have otherwise charged relentlessly upwards over the last three years and index investors have enjoyed one of the best periods in recent memory.

Well, it’s time for a reality check. No one knows when the bear will come out of hibernation, but it’s going to happen eventually. When it does, equity index funds can fall 20% or 30%, maybe more. That’s something we have not seen since 2011, so new investors haven’t been tested. If you’re holding an aggressive Couch Potato portfolio and you’ve never endured a bear market, I’ll bet you’ve overestimated your risk tolerance and could be in for a rude awakening.

Consider this: the Global Couch Potato lost more than 20% during the worst six months of the 2008–09 financial crisis—and that’s with a 40% allocation to bonds. An all-equity index portfolio would have been cut in half during that period. Going a back a little further, the aftermath of the dot-com bubble meant the Global Couch Potato returned -3.2% annually for the three years ending in 2002. Every investor needs to accept that such dark days can return swiftly and without warning.

The real skill is discipline

Indexers really shouldn’t gloat about the last several years, because they showed no skill in the traditional sense. After all, they didn’t pick any winning stocks or make any brilliant calls on where the markets were headed. They just showed up. But they do deserve credit for recognizing that’s the most important factor in long-term success.

Most investors come nowhere close to capturing the returns markets deliver. That’s because doing so requires the ability to stay disciplined when everyone is doing their best to distract you. It’s extraordinarily hard to endure the constant nattering of fortune tellers, doomsayers and well-dressed fund managers who make their living by urging you to stray from your long-term strategy. If you’re able to tune them out, then you’re among the investing elite.

Remember 2011, when Europe seemed on the verge of collapse and the U.S. had its credit rating downgraded? Well, during the three years that followed, stocks in both regions trounced Canada. And how about bonds, the asset class everyone loved to hate? During the last six calendar years bonds delivered over 5% annually, a result almost no one predicted. Just two examples of how the truly skilled investors are not the ones who are able to make shrewd economic forecasts. Rather, they’re the ones who recognize the futility of trying.

No one knows what the future will bring for the Couch Potato, but if you’ve read this far, you know that uncertainty is part of the deal. If you’re drawing up a plan, it’s reasonable to expect the long-term annual returns on a balanced portfolio will fall somewhere between a dismal 4% and a glorious 9%. It’s also safe to assume your journey will include periods where returns are far worse and far greater. The only way to enjoy healthy returns over the long run is to tough it out during those bad years and avoid getting cocky during the good ones.