This is your brain on potatoes

When Art Johnson started talking to clients about his investing strategy, he used a PowerPoint presentation filled with tables and graphs showing the proven benefits of broad diversification and low costs. It seemed like a good idea, but it didn’t work.

For years now, the portfolio manager with ScotiaMcLeod in Calgary has used a strategy similar to MoneySense’s own Couch Potato. The model has great appeal: it’s simple, cheap, and it routinely beats the pants off of most actively managed mutual funds. But as Johnson soon learned, no matter how compelling the data, Couch Potato investing can still be difficult. The problem isn’t the math: it’s the mind.

“I didn’t realize how much the psychology was a big deal,” says Johnson. “When you look at the numbers, everything seems clear, and clients responded well at first. Then we ran smack dab into human beings.”

MoneySense has recommended the Couch Potato strategy—also called index investing or passive investing—for more than a decade. If you’re not familiar with the idea, it involves building a portfolio of index mutual funds or exchange-traded funds (ETFs) that are designed to capture market returns at the lowest possible cost. It involves no stock picking, no tactical shifts, and no market timing: you simply choose a blend of stocks and bonds suited to your personal goals, and rebalance the portfolio back to those targets about once a year. (For more about Couch Potato investing, pick up the MoneySense Guide to the Perfect Portfolio, available at www.moneysense.ca/yield.)

The evidence supporting index investing is overwhelming. According to the most recent data from Standard & Poor’s, a mere 2.5% of actively managed Canadian equity funds outperformed the market during the five years ending in 2010. Bond index funds have an even more impressive track record, since it is extremely difficult for any bond manager to add value after costs, especially in the current era of low interest rates. There will always be examples of fund managers or individual investors who trounce the indexes, of course, but these are rare and impossible to identify in advance.

What Johnson found, however—and what many Couch Potatoes have learned on their own—is that human beings don’t make investment decisions after coolly assessing all the evidence. The growing field of behavioural finance has revealed that we all share mental biases and emotional stumbling blocks that prevent us from making good investing decisions. Blame it on our primitive brains. “Whether you’re looking out of a cave at a sabretooth tiger or looking at your portfolio going down, you react the same way,” Johnson says. “It doesn’t mean you’re a bad person. It just means your brain wasn’t wired for this.”

Index investing gets a lot easier once you become aware of the obstacles your brain will throw in your path. Here are the most common psychological hurdles you’re likely to face when you adopt a Couch Potato strategy, and some expert advice on how to leap over them.

1: An addiction to predictions

The human brain hates randomness and uncertainty, and we’re programmed to make predictions about the future, even when most of our previous forecasts were inaccurate. Ask anyone where they think the markets are headed, and you’re likely to get a confident reply, even though no one can possibly know that. As The Wall Street Journal’s Jason Zweig writes, “Presented with almost any data, your investing brain will feel it knows what’s coming—and it will usually be wrong.”

Couch Potato investors are not immune to this: we heard from many who adjusted their portfolios last year to include more Canadian stocks, or bonds with shorter maturities, because they were convinced these moves would earn them better returns than our “old portfolio.” Yet despite the sluggish economy south of the border, U.S. stocks dramatically outperformed Canadian ones in 2010. And who could have predicted long-term bonds would return almost 18% last year? No one, of course, and that’s the point.

The best defence against the impulse to make predictions is to look at the appalling record of market forecasters. In his book The Fortune Sellers, researcher William Sherden examined 25 years of market calls and economic forecasts and concluded that, as a group, they were no better than guesses, and no forecaster demonstrated consistent accuracy. Sherden’s advice: “Stop asking yourself, and everyone you know, ‘What’s the market going to do?’ It is an irrelevant question, because it cannot be answered.”

Our Global Couch Potato includes broad exposure to Canadian, U.S. and international stocks in all sectors, as well as bonds of all maturities. We don’t adjust the mix based on current market conditions, and it’s not because we’re too dim or too lazy. It’s because when the future is unknowable, the wisest move is to own a little of everything all the time.

2: The urge to pick stocks

Even committed Couch Potatoes often find it hard to be pure indexers. They may keep the bulk of their money in index funds or ETFs, but few can resist doing a little stock picking on the side—especially if they have a Y chromosome. “From my experience, few men can avoid stock picking,” says Andrew Hallam, author of the bestseller Millionaire Teacher. “How many people have fully indexed accounts? I would wager that only a small percentage do.”

For both men and women, stock picking holds out the promise of a big payoff, and your brain feeds on that kind of anticipation. The promise of financial reward causes your nucleus accumbens (the brain’s reward centre) to go haywire. Index investing, on the other hand, is about as stimulating as a four-hour lecture by an actuary who mumbles.

If you genuinely love the thrill, there’s nothing wrong with engaging in a little stock picking. Hallam, for one, strongly recommends indexing, but doesn’t think it needs to be all or nothing. However, he suggests limiting your stock picking to 10% of your overall portfolio.

Advisers who use passive strategies with their clients tend to agree. “I suggest they take $10,000 and pick stocks, but no more than that,” says Tony De Thomasis, a financial planner and president of De Thomas Financial in Thornhill, Ont. Sometimes the activity even reinforces the investor’s confidence in an index strategy. “After a couple of years they will often realize how difficult it is and they’ll give it up. They might do really well for two or three months in energy, or gold, but eventually they realize it’s not easy.”

3: Forgetting to save

Switching from high-cost mutual funds to a low-cost Couch Potato portfolio can boost your long-term performance by one or two percentage points all on its own. That’s a big deal—but it’s not enough to ensure financial success.

“If your goal is to retire with $1 million and you’re 47 years old and not saving any money, it doesn’t matter what you do with your portfolio,” says Frank Danielson, senior financial planner with Assante Wealth Management in Vancouver. “Whether you put it in a wrap program and pay 3%, or you use an index portfolio, or you pick stocks—that’s immaterial. Because that plan will be unsuccessful.”

There are several factors that determine your success as an investor, and the two most important are how much you save and the number of years you take advantage of compounding. But we don’t get any adrenaline rush from these. Instead, we tend to focus on the one factor we can’t control: our investment returns.

We’ve noticed this tendency among many young and aspiring Couch Potatoes who worry about saving a few basis points in fees, or agonize over the ideal asset mix, even though they have very small accounts. For now, these investors should focus on saving more, rather than on squeezing out an extra 1% from their portfolios. The fine-tuning can come later.

4: An inability to pull the trigger

Young investors with long time horizons may not be nervous about putting money in the markets today. But people who switch to the Couch Potato strategy later in life, after they have built a sizeable nest egg, often get cold feet. “What if I invest it all today and the market drops 5% next week? I’m going to feel like an idiot.”

The same emotions take over when it’s time to rebalance your portfolio, which means selling some of the best-performing asset classes and adding money to those that have gone down the most. Your brain doesn’t want you to do that. “Anyone who reads the paper doesn’t want to buy anything in Europe now because of what is happening,” says De Thomasis. “But there has never really been a period when people felt everything was peaceful and it was a great time to invest.” When recent returns have been poor, investors fear more of the same. When the markets have been kind, people worry everything is overvalued and due for a correction.

Art Johnson calls this “the amygdala hijack.” The amygdala (actually we have a pair of them) is an almond-shaped structure that acts as the brain’s panic button: it made your caveman ancestors duck when someone swung a club near their heads, and jump back when they stepped near a snake. It also makes you get sweaty palms at the prospect of losing money.

The antidote is falling back on a set of written rules. Whether you use an adviser or you invest on your own, you should have an investment policy statement (IPS) that specifies your asset allocation targets and how often you will rebalance. “You have to build in a rules-based strategy or it won’t work,” Johnson says. “You need to understand that your brain is going to fight you on this stuff.”

That said, if you’re terrified about investing a lump sum all at once, it’s perfectly fine to do so gradually. “Normally with large amounts, we will ease in over six to 12 months,” says De Thomasis. But again, follow a set of rules, such as investing one-quarter of the lump sum every three months.

5: Getting hung up on the products

A dozen years ago, being a Couch Potato was difficult, because there were very few index-tracking funds available. Today Canadians have an embarrassment of ETF choices, and it’s extremely easy to build a customized portfolio at rock-bottom cost. But in some ways all of these choices have made investors lose their way.

We’ve heard from many advisers who say their clients are asking about ETFs without understanding the principles of index investing. They’re focusing on the bricks and lumber rather than the building itself. “People look at things like the Couch Potato portfolio and think of it as a reliable product,” says Johnson. “But what you’re really espousing is a different way of thinking.”

When MoneySense introduced the Global Couch Potato in 2004, the only ETFs available were broadly diversified, cheap, and passive—indeed, those three qualities were the basis of the strategy. Now the market is filled with ETFs that are extremely narrow, expensive and actively managed. These may be useful for some investors, but they have nothing to do with being a Couch Potato.

Wearing yoga pants doesn’t make you fit, and swinging a titanium driver doesn’t make you a great golfer. In the same way, holding ETFs in your portfolio doesn’t make you a Couch Potato if you’re falling into the same old bad habits, like thinking you can outsmart the market. “People keep wanting to ignore the behavioural part and just focus on the products,” says Johnson, “but success only comes once you are willing to reframe your thought process.”

6: The feeling you’re missing out

Tony De Thomasis has lost count of the number of times clients have brought him media clippings with investing success stories—profiles of genius fund managers who beat the market over the last five years, or the amateur stock picker who struck it rich. “I always say, ‘So what?’ and it takes clients a while to get used to that, because they think they’re missing out on something.”

If you’re just able to earn market returns over your investing lifetime, you’re likely to outperform about 90% of professional money managers—let alone your brother-in-law or the guy at your kid’s hockey game. But you will never be number one in any given year, or even any period of several years. You can always find a strategy that would have worked better in the recent past (gold, anyone?), and that can make humble Couch Potatoes feel like chumps.

Part of the problem is that we’re conditioned to think that simple solutions are unsophisticated. Index investing doesn’t require studying company balance sheets, writing call options, positioning yourself on the yield curve, or any of those other things that might make active investors sound smart. These folks will often remark that the Couch Potato “is fine for people who aren’t able to do the research.” That’s nonsense: the point is that their research usually adds no value. “What may seem simple can be elegant and very sophisticated,” says Frank Danielson.

It may help to know that many of indexing’s staunchest advocates are finance professors with Nobel Prizes on their mantels. Academics may not use the term Couch Potato—they’re more likely to talk about “mean variance optimization” and “the efficient frontier,” which sounds way smarter—but they overwhelmingly favour passive investing. That’s because they focus on the data, not the anecdotes about investors who beat the odds. When you adopt the strategy, count yourself among the smart money.

7: An inability to think long term

“I get four years with a client before they start to tell me how to do my job,” says Art Johnson. “They say, ‘Art, you’re a nice guy, but you should be doing blank, because that’s what has done well over the last couple of years.’”

All reasonable investing strategies—whether the Couch Potato or an alternative—should be capable of enduring for a lifetime, but few people have the patience to think even a decade down the road. “Whatever has happened in the last three or four years ends up running the show,” Johnson says. “But people need to be careful not to keep dipping the ladle into the same punch bowl.”

One of our most powerful mental speed bumps is “recency bias.” That’s the tendency to put too much emphasis on the recent past. Gold, for example, has been a stellar performer since 2005, and many investors project this trend indefinitely into the future. Yet they ignore the fact that gold lost value from 1982 through 2004, even if you ignore inflation. As the financial author Larry Swedroe writes, “Falling prey to recency means trying to buy yesterday’s returns. You have to keep in mind that you can only buy tomorrow’s returns.”

Older investors can find it particularly difficult to stay focused on the long term, but even someone in their mid-60s should plan to be investing at least another 20 or even 30 years. “The biggest challenge we have in financial services is that our clients are probably going to live 10 years longer than they think,” says Johnson. “But if your brain is telling you that three years is a long time, how do you square that circle?”

Johnson suggests that investors think of their retirement portfolios like a personal pension plan. “That has fantastically changed our clients’ framing,” he says. “I start by showing them the asset allocation of a pension plan, and that is our benchmark.” Pension funds typically keep about a third of their assets in bonds and most of the rest in a diversified mix of Canadian, U.S. and international stocks—broadly similar to the Global Couch Potato. More importantly, these allocations don’t change much over time, because pension fund managers are less likely to chase performance and buy what’s hot. “This has been one of the best ways to encourage people’s brains to accept the fact that they have to be long term, and they have to think differently.”

Dan Bortolotti is author of the MoneySense Guide to the Perfect Portfolio, a step-by-step guide to Couch Potato investing, available online at www.moneysense.ca/equity

How to build your own Couch Potato portfolio

MoneySense brought the original Couch Potato portfolio to Canada in 1999 and created the Global Couch Potato in 2004. During the decade ending in 2010, the Global Couch Potato outperformed more than 85% of comparable balanced mutual funds.

You can build your own Couch Potato portfolio by opening an online discount brokerage account and purchasing the ETFs directly. But brokerages charge a commission (usually $10) every time you buy and sell ETF shares. So if you contribute frequently, or if you have a small account (less than $30,000 or so), it is more efficient to use TD’s e-Series index mutual funds. These have slightly higher annual fees, but they do not incur trading commissions. They can be purchased online with a TD Mutual Funds account or through TD Waterhouse, the bank’s discount brokerage.

The Global Couch Potato portfolios below use a conventional mix of 60% equities (divided equally among Canada, the U.S. and international) and 40% bonds. You can adjust this allocation to suit your own needs: conservative investors may want fewer stocks, while aggressive investors can opt for more.