The Couch Potato gets grilled

It sometimes feels like we introduced Couch Potato investing to Canada a century ago — perhaps because we did. The year was 1999. Back then, surrounded by the frothy euphoria of the dotcom era, we had only modest ambitions for our little spud. We hoped that Couch Potato investing might strike a few of our more thoughtful readers as a smart way to invest — smarter, at least, than simply buying a bucket of Nortel stock, which was what everybody else seemed to be doing at the time.

We weren’t prepared for the enthusiastic reception we received. Our Couch Potato article won a National Magazine Award. Letters from readers poured in, asking us for more information about how they, too, could put together a great portfolio in just 15 minutes a year. Over the next couple of years, as the dotcom mania crashed and burned, the Couch Potato emerged as one terrific tuber. And it’s continued to sprout success ever since. Each February we bring you up to date with how the Couch Potato portfolio is doing and each year we count on getting another thick sheaf of questions from would-be couch potatoes who want more information on our strategy.

This year, we thought we would try something new and ask for your questions first. We figured that after years of listening to us talk up the virtues of this strategy you should have your chance to grill the Couch Potato. So we posted a notice on our website and asked readers to send us their Couch Potato questions — the tougher and nastier, the better. Before we get to those questions, let us take a minute to introduce newbies to the Couch Potato way of life.

Couch Potato investing is based on the simple fact that beating the market is fiendishly difficult. Over periods of five years or more, 75% of actively managed mutual funds fail to keep up with their market index. (An index is simply a yardstick that measures the rise or fall of a specific market. The S&P 500 index tracks large U.S. stocks, for instance, while the S&P/TSX composite index tracks large Canadian stocks.)

Why can’t most mutual funds keep up with the index? Three words: High management fees. Most investors don’t realize it, but management fees gobble up about a third of your expected real return. A typical investor with a $200,000 portfolio pays enough in management fees to buy a new car every 10 years. Those fees drag the performance of most funds below the index.

So what do smart investors do? They become Couch Potatoes. Rather than spending huge amounts in a vain effort to beat the market, they take what the market has to offer — but they make sure they do so as cheaply as possible.

Couch Potato investing consists of buying a diversified basket of low-cost index funds. These funds passively track the stock and bond markets. By buying index funds, you ensure that you receive what the market delivers. You avoid paying big fees to money managers — and that, in turn, means more of the profits wind up in your own pocket.

Couch Potato investors do better than 80% of investors in actively managed funds over long periods. Since 1976, the Couch Potato has beaten the Canadian stock market by about a percentage point a year. Over the past 20 years (which is as far back as our mutual fund database extends), the Couch Potato has beaten the average Canadian balanced mutual fund by a percentage point and a half per year.

To find out more about the glorious history of Couch Potato investing, and to see how it’s performed over the past year, we invite you to visit our Couch Potato library. But right now, let’s get to your questions.

I’m confused. You publish the Top 200 ratings of individual stocks, but then you tout the Couch Potato strategy of buying index funds that track the overall market. Which is the right way to invest?
S. Riolino, Welland, ON

Good question. We don’t think there is one investing style that suits everyone. Your choice of strategy should reflect how much time you want to devote to the task of investing and also how much risk you want to take on.

Buying individual stocks makes a lot of sense for people who know their way around a balance sheet and who don’t mind taking on a bit more risk in pursuit of big payoffs.

Actively managed mutual funds also have their place. If you’ve studied the economy and you have a strong view on where the market is headed, you may want to sidestep the index and invest with a manager whose viewpoint agrees with your own. For instance, if you believe that global oil production has peaked, you might want to invest your money with a manager who loves oil stocks even more than the index does.

So where does that leave Couch Potato investing? While we don’t think it’s the only strategy that makes sense, we do believe that the Couch Potato is the best strategy for the 80% of us who don’t like analyzing financial statements and who don’t have a strong view about where the market is going next.

Couch Potato investing is based on the belief that the market is smarter than any single mutual fund manager — and smarter than most small investors, as well. You don’t try to outskate Sidney Crosby, you don’t try to outcook Martha Stewart, so why try to outinvest the market? Buy the market index and spend your time on more enjoyable pursuits than reading annual reports.

I think the Couch Potato is an excellent idea, but have not followed it because it has fallen behind the market over the past 10 years. Why isn’t it working any more?
M. Glister via email

An interesting question — because from our perspective the Couch Potato is doing just fine, thank you. It all comes down to what you mean by “the market.” You’re absolutely right that the Couch Potato has lagged a couple of percentage points behind the red-hot Canadian stock market over the past decade. But it’s done far better than the U.S. market over that same period; it’s also performed better than the Canadian bond market and better than the average Canadian balanced fund.

It’s important to remember that the Couch Potato isn’t a shootfor- the-moon strategy. It tries to produce good results with a low level of risk by spreading your money among Canadian and foreign stocks as well as bonds. At any given moment, the Couch Potato will be running ahead of some markets and behind others. That’s how diversification works: you parcel out your cash over several markets so that no single downturn can devastate you. But diversification cuts out the peaks as well as the valleys — you’ll never do quite as well as the top performing sectors, which, right now, happen to include Canadian stocks.

I’ve noticed other approaches from various writers that are similar to the Couch Potato. Is there a reason I should follow the Couch Potato as opposed to one of these similar strategies?
D. Giles, Vancouver

We’re very broad-minded Couch Potatoes. To us, Couch Potatodom includes everybody who a) cuts their investing costs by using index funds, and b) diversifies widely. So long as an investing strategy follows those two rules, we applaud it, even if it doesn’t follow one of our Couch Potato templates.

You’ll find some very good Couch Potato-like strategies in books by William Bernstein and Burton Malkiel. The Dick Davis Dividend, a new book by newsletter writer Dick Davis, compiles 28 model portfolios for index investors, including the original Couch Potato, which was designed by Scott Burns, a U.S. business writer. If you want to see the numerous ways in which you can invest in a Couch Potato-like fashion, you may want to buy Davis’s book.

In general, you’ll find that the true investing cognoscenti like to diversify more widely than the simple Couch Potato. They use many of the same building blocks, but they also devote tiny amounts of their portfolios to index funds that track sectors such as value stocks, precious metals, foreign bonds, commodities and REITs.

These are all excellent ideas in theory, but our experience is that most investors prefer simple strategies to more complicated ones. Before committing yourself to the Couch Potato or any other strategy, we encourage you to explore alternatives, then pick the level of complexity that suits your needs. So long as you keep your costs low and diversify widely, you’ll do just fine.

I am a fan of the Couch Potato portfolio, but was wondering if I should use the Canadian dollar versions of index funds in my portfolio or the currency-hedged versions.
W. Hui, Toronto

Many investors have been hurt by the huge run-up of the loonie over the past few months. Their U.S. holdings are now worth far less, in Canadian dollars, than they were a year ago. Understandably many of these investors want to know if they should insulate themselves from any further volatility in the loonie. And to meet that demand many fund companies are now offering versions of their funds that “hedge” away currency fluctuations.

Whether you should use these currency-hedged funds depends upon your tolerance for risk and your time horizon. If you don’t mind a bit of volatility and you’re investing for 10 or 20 years down the road, hedging your currency exposure isn’t worth the hassle, in our opinion. Canada’s currency may weaken over the next couple of decades or it may grow stronger — no one knows. So no one can predict whether hedging your currency exposure will hurt or help your results. On the other hand, if you hate the uncertainty of the markets and you need to draw on your portfolio in the near future, using currency-hedged funds makes sense simply as a way to reduce volatility.

Given the strong Canadian dollar, should the recommended ratios of index funds in your Classic Couch Potato portfolio remain the same? Or would the weakness of the U.S. economy suggest that an investor is going to be safer with more Canadian stocks?
E. Olsen via e-mail

The short answer is no. We don’t recommend changing the Couch Potato’s makeup because the core notion of the Couch Potato philosophy is that it’s difficult for anyone to know where the markets are going next.

If you try to chase success by jumping into a hot sector or running away from a cold one, you’re as likely to be wrong as you are to be right. So the smart strategy is usually to choose a reasonable asset allocation (like the Couch Potato or similar approach) and stick with it. This prevents you from being hypnotized by market fads and stops you chasing what was hot last year.

At the moment, lots of readers are encouraging us to devote more space in the Couch Potato portfolios to Canadian stocks because Canadians stocks have soared over the past five years. But trends have a way of changing, usually without warning. Back in 1999 and 2000, readers wanted exactly the opposite — they couldn’t figure out why we didn’t want to bet more on the soaring U.S. market, while dumping all those lacklustre Canadian stocks in the trash can! We’re sure glad we resisted the temptation to change back then, and we think Couch Potatoes who keep the faith will be similarly rewarded this time around.

Can I follow the Couch Potato in a non-registered account or is it only intended for RRSPs?
Alexis in Halifax

The Couch Potato works well in both RRSPs and non-RRSP accounts. (It does fine in RESPs, too, for that matter.) You may, however, want to adapt your Couch Potato approach to minimize taxes. In general, dividends and capital gains from stocks are going be taxed less heavily than payments f rom bonds. So if you’re Couch Potato investing in both your RRSP and non-RRSP accounts, it makes sense to think of both your RRSP and non-RRSP holdings as one big portfolio, and to put all your bond index funds in your RRSP, since they’re going to benefit the most from being tax sheltered.

How do you get started with Couch Potato investing?
V. Breen, Toronto

If you’re a novice investor, lean back and relax. Setting up a Couch Potato portfolio is easy.

Your first step should be to open up an account at a discount broker. Discount brokers don’t offer advice the way a full-service broker does. They are, however, much cheaper.

Discount brokers include BM O InvestorLine, CIBC Investor’s Edge, E*Trade Canada, RBC Direct Investing, ScotiaMcLeod Direct Investing and TD Waterhouse. You can find a complete list by visiting www.stingyinvestor.com and searching for “discount brokers.”

Discount brokers have websites that explain their fees and how they operate. If you don’t like doing things online, ask the folks at your local bank branch to help you open up an account at whatever discount broker they’re affiliated with — CIBC Investor’s Edge is affiliated with CIBC, TD Waterhouse with TD, and so on.

Your next step should be to read about Couch Potato investing and pick a specific Couch Potato portfolio you want to follow.

Next, consider how large your portfolio is and how often you’re going to be contributing to it.

If your portfolio is less than $100,000 or so and you want to contribute to it every paycheque, you should invest through index mutual funds. These are mutual funds that track a market index. Since index funds all do much the same thing — track an index — you should always go for the cheapest you can find. Every penny you save goes right into your own pocket.

To assess how cheap a fund is, look up its MER (management expense ratio) and compare it to other funds that track the same index. You should not pay more than a 0.9% MER for an index fund. (TD eFunds and Altamira provided the cheapest funds at the time of writing.)

The simplest Couch Potato portfolio is our classic model, which splits your money three ways. One third of your cash goes into a Canadian stock market index fund, another third goes into a U.S. S&P 500 index fund, the final third goes into a Canadian bond index fund. That’s it. Repeat as often as you wish.

The only twist comes if you intend to contribute to your portfolio only once a year, or if your portfolio is larger than $100,000. In both these cases, you may want to use what are known as exchange traded funds, or ETFs, rather than plain-jane index funds.

ETFs are index funds that trade like stocks on the stock market. They charge even lower fees than index mutual funds, but the catch is that you have to pay a brokerage fee every time you buy them, just as you would if you were buying a stock. (In contrast, mutual funds don’t charge you for making a contribution.) If you’re investing small amounts every couple of weeks, the brokerage fees that you run up in buying ETFs will probably amount to more than your potential savings, but if you’re investing only once a year, or investing large amounts, the savings from ETFs can be worthwhile. To find out more about ETFs, visit www.ishares.ca.