Are you tired of the poor performance of your actively-managed mutual fund? If so, a passive investing strategy is an alternative to paying a manager whose performance is beaten by the averages. Passive investing essentially means you are buying an index fund. It doesn't require a lot of time to set up, and it is usually the least expensive option.
Even the many mutual funds that mirror the performance of indexes involve risks. If the market goes down, your investments are guaranteed to suffer. How can you enjoy the low fees of passive investing while having sufficient diversification that provides an optimal risk/return tradeoff? In this article, we'll introduce you to the couch potato portfolio and show you a hands-free approach to managing your investments.
The Couch Potato Portfolio
This strategy was originally created by Scott Burns, a personal finance writer for the Dallas Morning News. The original strategy involved investing half of an investor's assets in an S&P 500 Index fund and half in a fund mirroring the Shearson/Lehman Intermediate Bond Index. Burns used the Vanguard 500 Index and the Vanguard Total Bond Fund Index. Investors with a higher risk tolerance could modify the 50/50 asset allocation strategy to 25% in the Vanguard Total Bond Fund Index and 75% in the Vanguard 500 Index. The 25/75 allocation is known as the "sophisticated couch potato portfolio". Ever since the concept originated, the couch potato strategy has been modified to suit individual needs from various countries. (To read more, see Index Investing, Indexes: The Good, The Bad And The Ugly and You Can't Judge An Index Fund By Its Cover.)
The Various Strategies
If you are a Canadian investor who wishes to create a portfolio that can be placed in your Registered Retirement Savings Plan (RRSP), you could use the version of the couch potato portfolio created by Moneysense.ca. Originally created as a strategy to implement Burn's couch potato portfolio, without pushing over the foreign content limit of 30% that used to exist for an RRSP account, the simple modification involves allocating one third of your assets to a Canadian bond index fund, one third to a fund that mirrors the S&P 500 index and one third to an index fund that tracks the S&P/TSX. Now that the foreign content limit has been removed, this modification is not necessary; but the added diversification that comes with adding another country to the mix, is not a bad idea. (For more, read Registered Retirement Savings Plans (RRSPs))
Alternatively, Canadian's can use the original couch potato portfolio created by Burns.
Regardless of which couch potato strategy is used, both require a yearly rebalancing of the portfolio in order to maintain the proportions in the chosen allocation. (Read Asset Allocation Strategies and Achieving Optimal Asset Allocation.)
How Well Does it Perform?
In Figure 1, the Canadian couch potato portfolio strategy created by Moneysense.ca has performed reasonably well, when compared to the returns of the S&P 500. If an investor had started with C$10,000 at the end of 2002, the investment would be worth $11,635 at the end of 2008. Compare this to the $2,653 loss that would have been seen with an investment in a fund tracking the S&P 500 stock index, and you can clearly see the benefit that diversifying across asset classes has created. This portfolio was created using one third of the Barclays Global Investors Canada S&P/TSX Composite Index Fund, one third of the Barclays Global Investors Canada S&P 500 Index Fund, and one third of the AGF Canadian Bond Fund.
In Figure 2, we compare the Canadian couch potato portfolio's performance with that of a portfolio based on the U.S. couch potato created by Scott Burns. As you can see, the added diversification of another country in the portfolio has helped over the 6 year period displayed. Although the portfolio still produced better results than the S&P 500 index over this time frame, it is clear that without the additional geographical diversification in addition to the asset class diversification, that this strategy produced losses. The U.S. couch potato portfolio shown in Figure 2 is composed of half the Barclays Global Investors Canada S&P 500 Index Fund, and half the Transamerica Life Canada US Bond Fund.
Why Does Laziness Pay Off?
The key is diversification. Diversifying your portfolio within both fixed-income and equity securities, and across geographical borders, allows an investor to limit losses during periods of bearish equity performance.
Consider, for instance, the stock market decline visible in the S&P 500 during 2007 and 2008. If an investor had chosen to allocate his or her assets 50/50 as in the original couch potato portfolio, the portion of the investment within the bond markets would have remained stable or performed well during a period of unrest within the equity markets. Figure 3 displays a direct comparison between the total returns of the S&P 500 and the U.S. couch potato portfolio utilizing this 50/50 strategy. As you can see, the 50/50 portfolio allowed for some of the volatility to be removed during the bear market starting at the beginning of 2007. As proven in Figure 2, taking it one step further with adding geographical diversification as well, the portfolio's volatility is reduced once again, as different country's stock markets often do not move with perfect correlation. (For more on this reasoning, read The Importance Of Diversification.)
Secondly, funds that mimic indexes will almost always have lower fees because of the passive investment strategy of managers of index funds. Fewer transactions translate into fewer expenses for the investor. The Barclays Global Investors Canada S&P 500 Index Fund used in the two portfolios above, for example, has a management expense ratio of only 0.67%. (Read Stop Paying High Mutual Fund Fees to learn more about the importance of low expense ratios.)
Thirdly, the return investor's gain is not a result of taking big risks. For the most part, this strategy offers sound gains while allowing investors to sleep well at night. Investors can purchase their funds, and just worry about rebalancing on a yearly basis. No short-term trading is required to keep this strategy profitable.
Conclusion: How to Do it Yourself
Are you better off with the advanced 75/25 strategy, the 33/33/33 Canadian strategy, or should you stick to 50/50 like the portfolio that Burns had originally created? The main issue here is the length of time, or time horizon, you have to work with. Investors wanting to expose themselves to more equity should have a longer investment horizon. Predicting the return on the stock market over a few years is difficult - if not impossible - but predicting over the long term is easier. Using history as our guide, we can be fairly confident that we will receive satisfactory returns when we invest for ten years or more. Those investors who don't have at least ten years to work with should consider taking a more conservative stance.
In addition, if an individual has any special tax considerations, the couch potato portfolio will not be as easy to create and may not be the most appropriate. We'd suggest you talk to a tax professional about this.
Most mutual fund companies offer index funds. Review their fees, and ensure that they are aligned with an appropriate benchmark. Morningstar is a great resource for finding funds, their fees and other important fund details. All you need to do is rebalance your portfolio once a year back to the 50/50, 33/33/33 or 25/75. Then, just sit back and concentrate on things other than investing.
In this case, it's okay to be lazy!
For more Canadian content, read Tax-Saving Tips For Canadian Taxpayers.