Busting the couch potato myths

For more than a decade, MoneySense has advocated an investing strategy designed to be so simple that anyone can do it. Its very name—the Couch Potato—suggests laziness, idleness, even sloth. You simply build a diversified portfolio of three or four index mutual funds or exchange-traded funds (ETFs), check in on it once a year, and otherwise let your money thrive on benign neglect. (If you’re new to the strategy, see How I became a couch potato.) Over the years, thousands of our readers have found success and peace of mind with the Couch Potato.

Unfortunately, based on the feedback we’ve heard, some investors run into speed bumps on the road to Potatohood. Sometimes the difficulties are practical, while others are more philosophical. In most cases, these problems can be traced back to myths and misunderstandings about how and why the Couch Potato works.

If you’re thinking about adopting an indexing strategy—or if you’ve recently made the leap and are still full of questions—we want to make sure your journey has as few surprises as possible. It’s time to break down the most common Couch Potato myths, based on first-hand experiences from regular investors who encountered and overcame them.

Myth 1: It’s easy to stay the course
Mary Long-Schimanke barely gives her index portfolio a second thought: she makes her RRSP contribution once a year, rebalances at the same time, and then ignores it. “I used to worry about it, but I don’t anymore,” says the Edmonton investor. “I’ve never considered changing it, or pulling out of the market.”

Long-Schimanke has the ideal temperament for Couch Potato investing. But many people who adopt a passive strategy are surprised by just how difficult it is to follow her lead. “When you switch to the Couch Potato, one of the hardest things is giving up the mindset you had in your old investment ways,” says James Wisener, a software engineer in Ottawa. He and several of his colleagues switched to index funds last summer when their employer started offering them through a group RRSP. He admits it’s been hard to ignore the pundits. “Like when Warren Buffett recently came out and said you shouldn’t be buying bonds—I remember one of the guys at work saying, ‘Maybe we should stop putting money into the bond fund and move it somewhere else.’ It’s hard to turn that off.”

New Couch Potato investors should be prepared for temptation. Like a dieter walking by the dessert table, you will feel the urge to abandon your plan. Both the financial industry and your own human instincts will conspire to make you feel like you have to constantly adjust your portfolio to keep up with market conditions.

There are two things you can do to help resist these temptations. The first is to read up on financial history: you’ll soon appreciate that all the evidence suggests forecasting is not merely futile, but harmful. (At the very least, search the web to see what market gurus predicted for 2010. As usual, many of the consensus opinions—notably poor returns from long-term bonds, and a sideways stock market—turned out to be spectacularly wrong.)

The second antidote is making a plan. Choose a stock-bond mix that suits your risk tolerance, and determine exactly when you’re going to rebalance back to that target. This takes the emotion out of the decisions. “When things started going haywire in 2008, what saved me was that I had a plan in place,” says George Wenzel, a federal public servant in Edmonton who has been an index investor for more than seven years. His portfolio contains 40% bonds, 30% Canadian stocks, and 30% U.S. stocks. Whenever one of those allocations veers off course by 5%, he sells some of the winners and adds money to the losers, rebalancing back to his target. That strategy served him well when stocks started plummeting in the fall of 2008, and again in early 2009. Instead of panicking, Wenzel stuck to his plan. “Whenever things dropped, I reallocated and bought more equities. I just did it based on percentages.”

Myth 2: The Couch Potato is all about low fees
One of the primary benefits of Couch Potato investing is that it’s dirt cheap—switching from actively managed mutual funds to ETFs can reduce your annual fees by as much as 90%. But successful index investors understand that low costs are only part of the formula for success. It’s even more important to reduce the behavioural mistakes that all of us are prone to making. “Passive investing is fundamentally about changing the way you act,” says Art Johnson, a portfolio manager with HSBC Securities in Calgary.

For most of the last century, the main obstacle small investors faced was the high cost of buying stocks, bonds and mutual funds through dealers who took a hefty cut. Since index funds and ETFs have become widespread, that obstacle has disappeared. Yet, as a group, individual investors still have a terrible performance record. “It’s great that we have these tools now, but the critical ingredient is still changing your behaviour. Just because you use passive products doesn’t mean you’re going to act differently.”

Humans are hard-wired to sabotage themselves as investors. “It’s just who we are,” says Johnson. “It’s in our makeup.” We’re overconfident. We think we can forecast the markets. We put too much emphasis on the recent past. We have a poor understanding of risk. We alternate between too greedy and too fearful. Even investors who use low-cost funds can get into trouble if they can’t learn to recognize these biases and resist acting on them.

We hear from investors like this all the time. They ask us why our Global Couch Potato portfolio (see Couch Potato Portfolio: How to set it up) includes international stocks, when “everyone knows” that the debt crisis in Europe will lead to lower returns in the coming years. Some are convinced that the U.S. is in a downward spiral and don’t want to invest in the world’s largest and most diversified economy. Others, like James Wisener’s colleague, talk about getting out of bonds, which are “guaranteed” to lose money because interest rates are likely to rise. These concerns may sound reasonable now, but what will these investors do in a year or two, when conditions change? Will they realign their portfolios again based on a new set of forecasts? If they do, they’ve missed the whole point of being a Couch Potato. In fact, they’ve become active managers themselves.

Myth 3: Dumping your old funds is easy
One of the most surprising things we’ve learned from our readers is just how much resistance they’ve faced when trying to switch to a Couch Potato portfolio. No one was expecting that their financial advisers would welcome the change with open arms—after all, advisers usually have a vested interest in the high-fee products they sell—but we were taken aback by the stubbornness that many investors encountered.

When Mary Long-Schimanke read about the Couch Potato portfolio in MoneySense, she went to a bank that offers index funds and asked how she could buy them. “The person I dealt with didn’t have a clue what I was talking about,” she remembers. Instead, the bank staff prodded her to set up an appointment with one of their advisers. Long-Schimanke was confident enough to push back, but the sales pitch was so strong that she decided to tag along when her daughter went to open her own Couch Potato account a few months later. “If I hadn’t have been there and been firm, I’m positive she would not have been able to get the index funds.”

We’ve heard dozens of similar stories. Investors who end up making an appointment with advisers are often scoffed at and told that indexing is “unsophisticated.” The advisers are prepared with a list of cherry-picked funds that have recently beaten the market. It takes a confident and knowledgeable investor to stand up to this pressure.

As indexing grows in popularity—and ETF assets hit $1 trillion in 2010—many commission-based advisers are feeling threatened, says Art Johnson, the portfolio manager. “Our business has been like the priest who says, ‘I’ve got access to the Latin book, and you don’t. Come through the clergy and get the knowledge.’ Then ETFs came along and now the clergy is terrified.”

It’s also important to understand that many mutual fund dealers are not licensed to sell exchange-traded funds. “I asked my last adviser to give me some information on ETFs,” says Dale Bingley, an investor in Ottawa. “Eventually, after trying to put me off, she finally told me she didn’t know enough about the products to advise me on them.”

The truth is that switching to index funds or ETFs will often mean firing your current adviser. Fortunately, there are Potato-positive advisers like Johnson, who are compensated directly by their clients. “Fee-only” financial planners often bill by the hour or by the project, while portfolio managers charge about 1% of the assets they manage—so if you have a $300,000 portfolio, expect to pay about $3,000 annually. Most use a sliding fee scale, so the percentage goes down as your account size goes up. Because these advisers receive 100% of their compensation from their clients—many are not licensed to sell investments—they have no incentive to steer you toward specific products. (Note that “fee-based” advisers are different: they make their living both from client fees and commissions from products. Before hiring an adviser, ask him or her how she is compensated.)

Myth 4: Anyone can go it alone
Not everyone is prepared to pay an adviser, and not everyone needs to. Many MoneySense readers have had great success managing their Couch Potato portfolios on their own. However, not everyone is cut out to be a DIY investor.

Take Dale Bingley, for example. When she was 47, her husband passed away and she received his pension savings as a lump sum. “I am incredibly lucky to have a substantial nest egg,” she wrote to us, “but the responsibility of managing it in today’s environment is overwhelming.”

Bingley had “one bad experience after another with a string of financial advisers,” so when she read about the Couch Potato portfolio in MoneySense, it appealed to her. But she had no idea how to implement it. “To the more experienced investor, making the switch to the Couch Potato strategy all sounds very easy. And once I’ve done it, I will probably agree. But for the most part, it’s the how-to stuff that has me still sitting on the fence instead of on the couch.”

Bingley isn’t sure how to open a discount brokerage account and purchase ETFs. A lot of her money is tied up in mutual funds with deferred sales charges, and she doesn’t know whether to sell these all at once or gradually. She’s not certain what mix of stocks and bonds is right for her. Not surprisingly, she’s just not sure she’s ready to go it alone—and she shouldn’t. Bingley would benefit from the services of a fee-only financial planner, who can draw up an investment road map for her to follow.

That isn’t to say that all inexperienced investors should abandon the idea of managing their own money. As Bingley points out, a lot depends on your personal situation. “New, inexperienced Couch Potatoes are often young and starting out with a small investment. They will have time to adjust and learn from their mistakes.”

Several readers have told us that it took them time to feel confident making trades through an online brokerage account, for example. Do you know the difference between a market order and a limit order? Do you know how to check an ETF’s trading volume? Did you know that your brokerage can charge hefty currency conversion fees when you buy U.S.-listed ETFs? If not, then you can boost your confidence by taking advantage of the online tutorials offered by most discount brokerages.

Nadine Fletcher, a nature guide in Lake Louise, Alta., and a newly minted DIYer, found that when she was nervous about buying ETFs, she simply called her brokerage and asked for guidance. Discount brokerages are not allowed to give you investment advice, but they can walk you through the steps of making a trade. (Make sure you’re the one doing the actual clicking, however, or you may be charged an additional fee.) “It was nice to have someone there to reassure me to say, ‘Yes, the trade has gone through. Go to this screen and you’ll see it online.’”

If you want to be a Couch Potato without opening a discount brokerage account, consider getting your feet wet with TD’s e-Series index funds (these are great even for experienced investors) or ING Direct’s Streetwise Funds, both of which are available online.

Myth 5: ETFs are always better
Most discussions about Couch Potato investing revolve around ETFs rather than index mutual funds. There are good reasons for this: ETFs offer far more variety and often have much lower management fees. But ETFs still have one significant drawback: buying and selling them incurs trading commissions. Depending on your discount brokerage and the size of your account, these commissions range from $5 to $29. If you have a small portfolio, or if you plan to add money every month, these trading costs will cancel out any benefit you would have received from the ETFs’ low annual fees.

Here’s an example. Suppose you want to invest $30,000 in the Global Couch Potato portfolio and you’re not sure whether to use four ETFs or four index funds. You learn that the ETFs have a management fee of 0.35% annually (which works out to $105 on your $30,000 investment), while index funds will cost 0.70%, or $210 per year. Seems like a no-brainer, right? The ETFs are half the price.

But that ignores the trading commissions you’ll pay when you buy the ETFs. You’ll have to make four trades to set up the portfolio, and even if you plan to add money only once a year, that’s four more trades annually. If your brokerage charges $29 per trade this will add an extra $116 to your annual costs—which makes the ETF option more expensive than the index funds.

If your discount brokerage has very low trading fees, it may be cost-effective to build an ETF portfolio for less than $50,000, especially if you’re only making annual lump-sum additions, but do the math first.

Myth 6: You’ll see improved results immediately
Last fall, we received an email from a reader who wasn’t happy with the way his ETFs were performing. When he built his Couch Potato portfolio, he also assembled a hypothetical portfolio of dividend-paying stocks so he could compare the performance of two. Well, it had been two months, and his stocks were in the lead. Two months?

Thankfully, most investors are more patient than that, but we’ve heard from many others who seem to think the Couch Potato strategy is a magic formula. It’s not: indexing works, but it can take years for the benefits of low costs, broad diversification and discipline to reveal themselves. Art Johnson, the portfolio manager, explains it this way: “When I play golf and I hit a ball into the woods, I see it right away. Well, imagine hitting a golf shot and then not knowing where the ball landed for five years. Investing is like that: you don’t get immediate feedback.”

When James Wisener adopted an indexing strategy through his employer’s RRSP, he also kept an actively managed portfolio with his adviser and issued a friendly challenge: “I called him up and said, ‘From now on you don’t have to beat the TSX or any of these other indexes. You have to beat my index portfolio.’ So we started a little competition.” Last time he checked, the adviser was ahead, but Wisener’s not worried. “It’s been such a short period of time. This isn’t a miracle, or a get-rich scheme.”

Wisener has the right idea, but other investors who are considering moving from active funds to index funds say things like, “I’ll try this for a year and see how it goes.” That’s fundamentally the wrong mindset. Every year, many funds will beat their benchmarks, and some will do so for three, five, or even 10 years. The problem is that no one can identify these winning funds ahead of time, and past performance doesn’t predict the future.

So if you’ve just dumped a high-cost mutual fund and then watched in dismay as it went on to have a great year, don’t kick yourself. Outperformance rarely lasts long. And remember, if you’re building a globally diversified portfolio of stocks and bonds, it’s not enough to pick one winning fund: you’ll need to pick at least three or four. That’s extremely difficult to do in the short term, and almost mathematically impossible over a 20- or 30-year investing horizon. “As more actively managed mutual funds are added to the portfolio, the outperformance rate for the total portfolio drops dramatically,” Richard Ferri writes in his new book, The Power of Passive Investing. “The problem compounds over time, and after enough time, the probability for outperforming a passive approach drops to near zero percent.”