Couch Potato Portfolio(ZT)

Couch Potato Portfolio

There are people out there, and we've met plenty of them, who spend hours every week sweating over their investments. Some of these investing junkies actually seem to enjoy reading balance sheets and analysts' opinions.

Most of us, though, aren't like that. We want good performance with low risk — but between our jobs and our families we don't have a lot of time to follow the market.

If that sums up your situation, MoneySense has the perfect portfolio for you. It will not only beat the performance of most people who spend hours on their investing, it will beat about 80% of the money managed by professionals. Best of all, like an ideal houseplant, this portfolio thrives on neglect. It performs superbly even if you pay attention to it for only 15 minutes a year.

We call our approach the Couch Potato strategy. It's based on the simple fact that the market is smarter than any single individual. If the market says a stock is worth $20 a share, chances are the stock is probably worth somewhere close to $20 a share.

This may surprise you. Most market commentary is geared to making you believe that there are scads of undiscovered bargains out there. But think about how the world works and you realize how unrealistic that proposition is.

On any given day, thousands of highly paid, highly competitive mutual fund managers and pension fund experts are scouring the market looking for bargains. When they think a stock is undervalued, they buy it. All that buying forces up the price of the stock until it's trading for what most investors believe is fair value. Similarly, if the pros believe a stock is overvalued, they sell it and keep on doing so until the stock meets their definition of fair value. Thinking that you're going to beat the system and turn up lots of great, undiscovered stocks is a bit like thinking you can wander into a thoroughly explored wilderness and spot a gold mine that all the professional geologists just happened to overlook.

The best proof of the market's intelligence is that even the professionals can't keep pace with it. Over any period of a few years or more, about 80% of actively managed mutual funds lag behind the market. They're weighed down by the salaries of their managers, by research costs, by marketing expenses, by fees paid to financial planners, by trading expenses.

Here's where the Couch Potato strategy comes in. It's based on a simple idea: if active management doesn't beat the market, why not dump it and buy the market instead?

You buy the market by investing in a small collection of low-cost index funds. These funds passively follow the ups and downs of market indexes, such as the S&P/TSX Composite index of Canadian stocks or the Standard & Poor's 500 index of U.S. stocks. Your exact mix of funds can vary (and we'll get to the details in just a second), but the key advantage of the Couch Potato strategy is that it gives you wide diversification among hundreds of stocks and bonds at rock-bottom cost.

Why is this so important? Because low costs are crucial when it comes to investing success. Most investors pay about 2.5% of their assets each and every year to invest in actively managed mutual funds. On the other hand, you can become a Couch Potato for 0.5% a year or less. The couple of percentage points you save go directly to your bottom line and can have a tremendous effect over time.

Let's say you have a $200,000 portfolio. This year alone you would save about $4,000 by becoming a Couch Potato investor rather than an investor in actively managed mutual funds. Over a few years, assuming you reinvested all of your savings, the difference would grow and grow, because the money you would be saving would compound on itself. Assuming typical rates of return, the money you would save by becoming a Couch Potato would be more than enough to buy you a luxury car in 10 years' time even if you were never to invest another cent in your portfolio.

Whenever we lay out the math, people are naturally skeptical. It seems too good to be true. How can the mutual fund industry get away with charging us so much for so little? Doesn't all that expensive professional management accomplish something?

Sadly, no. If you doubt us, click here to see how our Classic Couch Potato portfolio has generated returns higher than 11% over the past 30 years. Or visit Scott Burns' site at Dallasnews.com and see how Burns, the inventor of the original Couch Potato approach, has fared. Compare the Potato's results to what the average actively managed mutual fund has accomplished — we think you'll be impressed. Then, if you want to better understand the reasoning behind Potato-hood, pick up Unconventional Success. It's a new book by David Swensen, the legendary investor who piloted Yale University's huge endowment fund to record-breaking performance. In his book, Swensen lays out a Couch Potato-like strategy of his own. Coincidence? We think it's merely another affirmation of the Couch Potato's unarguable logic.

The Potato is ultimately about common sense. It rests on three ideas:

The first idea — as we've already seen — is to keep your costs low. This ensures that you, not your financial adviser, reaps most of the rewards from your portfolio.

The second idea is to diversify among different types of assets. By doing so, you ensure that no single blow-up can devastate your portfolio. We usually recommend that Couch Potato investors follow a classic balanced strategy, which consists of putting 60% of your money in stocks and 40% in bonds, but you may want to adjust the stock component upward if you're young and willing to take on additional risk in pursuit of larger returns. Conversely, you may want to dial down the stock portion if you're older and more conservative.

The third idea is to rebalance once a year to get back to your original asset allocation. If your stocks shoot up in value, for instance, you would sell some and put the proceeds into bonds. Doing so ensures you're constantly selling high and buying low.

That's it. If you follow those three ideas, you're going to do well. In fact, you can adapt the Couch Potato strategy to suit your individual situation and preferences. Our Classic Couch Potato Portfolio is a simple strategy that spans Canadian and U.S. markets. Our Global Couch Potato Portfolio takes things a step further and expands your portfolio to span the world. Both are just suggestions and can be tweaked to suit your purposes.

Ready to get going? We suggest you read our Couch Potato FAQs for a quick overview of the major issues. Then follow Do the Couch Potato for a step-by-step guide to implementing the strategy. Finally, visit Meet the potato family and choose the Couch Potato strategy that's right for you.

The Couch Potato Portfolio FAQs

What is the Couch Potato Strategy?

It's a way of investing that relies upon index funds or exchange-traded funds (ETFs). These funds passively track the major stock markets and bond market at very low cost. You put your money into a pre-determined blend of these funds to get wide diversification across different types of stocks and bonds. Once a year you sell off some of your winners and put the proceeds into your losers so your portfolio returns to the original proportions.

What's so smart about that?

Since you're paying less in fees than most mutual fund investors, more of the profits go into your own pocket. Also, your wide diversification means that no single disaster can blast a hole in your returns. Finally, the annual rebalancing means that you're selling high and buying low — which is a much smarter way to invest than the opposite approach.

But isn't it risky not to have a manager looking after my investments?

Not at all. You can think of the stock market or the bond market as being the sum total of all the mutual fund managers out there. When you buy the market index you're essentially getting the collective opinion of thousands of investment professionals. And that's likely to be smarter than the opinion of just a single manager.

But surely a good manager must perform better than the market?

When you look at results over several years, about 80% of actively managed funds lag behind the market. That's no knock on the people who run them — the truth is that it's mathematically impossible for the majority of mutual funds to beat the market average, because they are the market. Just as most students in a class can't be above the class average, neither can most mutual funds. And actively managed funds labor under a big handicap. They have to pay hefty fees for managers, research, marketing and trading. Those fees usually amount to more than 2% of their assets and are a heavy drag on their results. In contrast, you pay less than 0.5% of your assets to invest in most indexing alternatives.

But some actively managed funds do beat the market. Why not invest in them?

That would be a great idea — if you could predict the right funds before the fact. The problem is that nobody's ever been able to figure out a foolproof way to peer into the future and predict which funds will do best over the next few years. The best approach we've seen to picking actively managed funds is Suzane Abboud's. But we think that our Couch Potato strategy is simpler, more dependable and less prone to being thrown off course by a manager's retirement or defection.

Why are you recommending this approach?

Because we think it's smart. We're not reaping any fees from the Couch Potato. Nor are we recommending the Couch Potato as a way to get rich quick. We see it instead as a useful way to manage the core of your portfolio and get good to excellent returns.

What returns can I reasonably expect?

"We have 70 years of data that supports the fact that there's a long-run central tendency for nicely balanced portfolios to come in somewhere around 8% to 10%," says Eric Kirzner, the John H. Watson chair in value investing at the University of Toronto's Rotman School of Management. "With a long enough investment horizon, there's a high probability that you'll achieve at least a decent 8% average annual return."

Is it important for me to stick precisely to the formula you outline?

No. Couch Potatoes come in many shapes and the basic recipe can be adapted to meet your own needs. Check out Meet the Potato Family for some models. As long as you keep your costs low, diversify and rebalance to your pre-determined asset allocation once a year, you'll do fine.

Are there any pitfalls?

We're glad you've asked. There are two that come to mind. One is buying expensive index funds — some companies, believe it or not, charge nearly as much for index funds as they do for actively managed funds. Since index funds' major advantage is their low cost, this defeats their purpose. You should pay no more than 0.5% a year for an index fund. The best deal we're aware of right now comes from TD eFunds.

The other major pitfall is changing your asset allocation each year based upon whims. If the stock market is booming, it's tempting to ignore your long-term asset allocation and load up on stocks. Similarly, if the market is in the dumps, you may want to hide out in bonds. At times like this you have to remind yourself that the entire purpose of asset allocation is to ensure that you're never taken by surprise by the market's next move. Once you've chosen an asset allocation, stick to it for at least a few years.

Do the Couch Potato

If you're interested in becoming a Couch Potato, you must first decide whether you will be investing only once a year or through regular monthly contributions.

If you're investing once a year, you should use exchange-traded funds or ETFs. These are index-fund-like investments that trade like stocks on major stock exchanges. Many ETFs charge ultra-low management fees (think 0.3% or less), but to buy or sell them you have to pay a brokerage fee just as if you were buying a stock. The fees aren't huge in themselves — $30 is typical — and if you're investing once a year, they are a minor annoyance when you consider the low management fees you're paying.

On the other hand, if you want to contribute monthly, paying $30 a pop for each transaction can send your overall bill soaring. You're better off to use index mutual funds. You'll pay a bit more in management fees, but you won't face brokerage fees on every contribution.

For purposes of illustration, we'll assume you're using our Global Couch Potato strategy (for other strategies, see Meet the potato family).

Once-a-year investors: Open a discount brokerage account. Deposit your money, then divide the total amount by five, and buy these ETFs:

The first pile
• (20% of your money) goes in the iShares Canadian Composite Index Fund [TSX: XIC]. (We've decided to replace the i60 Fund recommended in previous articles with this new, more diversified fund, but if you already have the i60, there's no need to switch.)

The second pile
• (20%) goes in the iShares Canadian S&P 500 Index Fund [TSX: XSP].

A third pile
• (20%) goes to iShares Canadian MSCI EAFE Index Fund [TSX: XIN].

Both the fourth and fifth piles
• (A total of 40%) go in the iShares Canadian Bond Index Fund [TSX: XBB].

Once a year, buy and sell your ETFs (or add new money) to get your portfolio back to its 20%-20%-20%-40% split.

The net result of all this is a very low-cost portfolio that has 60% of its money invested in a wide range of stocks in Canada, the U.S. and around the world, and 40% invested in Canadian bonds.

Monthly contributors: For purposes of illustration, we'll use TD eFunds, because they're particularly cheap. As above, you start by transferring your money into the account and splitting it up into five piles:

One pile
• (20% of your money) goes in the TD Canadian Index Fund.

The second pile
• (20%) goes in the TD U.S. Index Fund.

The third pile
• (20%) goes in the TD International Index Fund.

Both the fourth and fifth piles
• (40%) go in the TD Canadian Bond Index Fund.

Once a year buy and sell your funds (or add new money) to get them back to their original split.

That's it. Now sit back, put up your feet and enjoy life as a couch potato.

Past performance: Classic Couch Potato performance, Global Couch Potato performance.

Meet the potato family

The Couch Potato strategy can be adapted in many ways.

We've listed some examples below and demonstrated how you would allocate your assets for each strategy.

To figure out exactly which securities you should buy, see Building blocks for the names of specific ETFs and mutual funds.

Classic Couch Potato

The original and the simplest. You split your money into three equal parts and invest as outlined below. Once a year, you rebalance to get back to your original asset allocation:

1) Canadian equity (33.3%)
2) U.S. equity (33.3%)
3) Canadian bond (33.3%)

Global Couch Potato

This portfolio is more diversified than the Classic, and thus should have less risk. It spans the world by splitting your money into five equal piles. Two of those piles go into Canadian bonds; the remainder are invested in Canadian, U.S. and international stocks:

1) Canadian equity (20%)
2) U.S. equity (20%)
3) International equity (20%)
4)+ 5) Canadian bond (40%)

High-Yield Couch Potato

If you want a portfolio that delivers steady income and allows you to take advantage of the government's tax break on dividends, this might be the portfolio for you:

1) Canadian dividend (25%)
2) Income trusts (25%)
3) U.S. dividend (25%)
4) Canadian bond (25%)

High-Growth Couch Potato

This portfolio has a higher exposure to stocks. It's more volatile than other Couch Potatoes, but may produce higher returns over time:

1) Canadian equity (25%)
2) U.S. equity (25%)
3) International equity (25%)
4) Canadian bond (25%)

To figure out exactly which securities you should buy, see Building blocks.

Updated January 24, 2007

Building blocks

You can snap these exchange-traded funds (ETFs) and index funds together to make your favorite Couch Potato portfolio. Once-a-year investors should use iShares, which charge extremely low fees and trade on the Toronto Stock Exchange. Monthly contributors should use TD eFunds, which charge slightly higher fees but don't require you to pay a brokerage fee each time you buy or sell.

Canadian equity
iShares Canadian Composite (TSX: XIC)
TD Canadian Index Fund

U.S. equity
iShares Canadian S&P 500 (TSX: XSP)
TD U.S. Index Fund

International equity
iShares Canadian MSCI EAFE (TSX: XIN)
TD International Index Fund

Canadian bond
iShares Canadian Bond (TSX: XBB)
TD Canadian Bond Index

Real estate
iShares Canadian REIT Sector (TSX: XRE)

Canadian dividend
iShares Canadian Dividend (TSX: XDV)

U.S. dividend
iShares Dow Jones Select Dividend (NYSE: DVY*)

Income trusts
iShares Canadian Income Trust Sector (TSX:XTR)

*offered by iShares in the U.S.

Updated January 24, 2007

Classic Couch Potato performance

If you invested $100 in the Classic Couch Potato portfolio on January 1, 1976, it would be worth $3,163.45 as of December 31, 2006.