The 50-Percent Solution

• Should I use fundamentally weighted or traditional cap-weighted ETFs?
• Should I hedge the currency in my US holdings?
• Will dividend-focused equities outperform a broad-market ETF?
• Short-term bonds or a broad-market bond fund?

All of these are thoughtful questions, but each involves a choice between two good alternatives: one is likely to turn out better over the long run, but there’s no way of knowing which one. And yet I regularly hear from readers who are sitting in cash—or worse, sitting in overpriced mutual funds—because they can’t decide which alternative to take.

There are lot of big questions in investing. Whether you use a stock-picking strategy or a passive Couch Potato portfolio matters a lot. Hiring an advisor or investing on your own will also make a dramatic difference. Dumping your GICs for high-yield bonds without understanding the risk? Definitely huge. Decisions like those above—where both alternatives are reasonable, and the superiority of one cannot be predicted—are much smaller. It’s worth spending time weighing the pros and cons. But they’re not worth agonizing over if they leave you paralyzed.

If you’re on the horns of an investing dilemma, here’s a suggestion: do both. Just split the decision 50-50. If your portfolio has 20% Canadian equity, put 10% in a broad-market fund such as XIC and the other 10% in either a fundamentally weighted (CRQ) or dividend-focused ETF (CDZ or XDV). Put 50% of your fixed income in XBB, which covers all the bases, and the other half in a short-term bond ETF. Hedge all the currency in your RRSP and leave it unhedged in your spouse’s. (A couple of commenters on my recent post on currency hedging suggested exactly this. It’s what I do with family’s investments, too.)

The real danger for investors here is not making a dumb call, but regretting a reasonable call that just turned out badly. If you hem and haw before eventually deciding to use cap-weighted ETFs, how will you react if fundamental indexes outperform over the next two years? If you decide to go with short-term bonds only, will you be frustrated if long bonds end up doing better? If it turns out that you were “wrong,” will you chase the returns of the fund that turned out to be right? This kind of second-guessing—and the ill-timed trading it inspires—will be far more detrimental to your returns than a few basis points in a fund’s MER or yield.

Even the great Harry Markowitz wasn’t immune to the paralysis of indecision. Markowitz won the 1990 Nobel Prize in Economics for creating Modern Portfolio Theory, the idea that having uncorrelated asset classes in a portfolio can both increase returns and reduce risk. Yet even he could not bring himself to follow his own advice: “I should have computed the historical co-variances of the asset classes and drawn an efficient frontier,” he wrote, but instead “I visualized my grief if the stock market went way up and I wasn’t in it — or if it went way down and I was completely in it. So I split my contributions 50–50 between stocks and bonds.”

Trying to determine the optimal way to build a portfolio is a worthwhile goal. But never forget that human behaviour is the biggest enemy of investor returns. When choosing between two reasonable options, the best choice is the one you can live with.