Millionaire Teacher
Page 14
Such a strategy, despite its very conservative nature, would have averaged 10.96 percent annually from 1986 to 2001.3
This would have turned $1,000 into $4,758.79 over that 15-year period.
But a drunken monkey tossing darts at the stock market page could have made decent money from 1986 to 2001, because most of the world’s stock markets rose like a hot air balloon. How did the indexed couch potato strategy perform when stock markets went through their gut-wrenching dives and rises (and dives again) during the next 10 years—a decade that many stock market investors have coined “the lost decade?” For starters, the indexed couch potato strategy let investors sleep more soundly during market drops, thanks to the large bond component.
During 2002, the US stock market was hammered. The average US stock market mutual fund declined 22.8 percent in value. In other words, an investment of $10,000 would have fallen to $7,723. But during that devastating year, the markets were able to knock the couch potato strategy down only 6.9 percent. A $10,000 investment would have dropped to $9,310.4
Between the beginning of 2003 and the beginning of 2008, the US and international stock market indexes rose dramatically, gaining 91 percent and 186 percent, respectively.5 If you had money in the markets during these five years, you probably would have increased your portfolio size a lot, no matter who was managing it. But let’s have a look at one of the ugliest years in modern financial history: 2008.
With the global economic crisis, world stock markets took a beating. Of course, long-term investors should have gleefully rubbed their hands. They could take advantage of lower prices. But let’s see how the average US mutual fund and the couch potato portfolio would have fared during that falling market.
If you thought the average professional could have weathered the storm, you’d be disappointed. Table 5.1 shows that the average actively managed stock market mutual fund (comprised of stocks, without bonds) dropped 29.1 percent in 2008, compared to a drop of 20.4 percent for the indexed couch potato portfolio. And how about the average actively managed balanced fund? Balanced funds don’t have the same kind of exposure to the stock market that regular stock market mutual funds have. Balanced funds are usually comprised of 60 percent stocks and 40 percent bonds. When stocks fell dramatically in 2008, the bond component of the average actively managed balanced fund should have cushioned the fall. But that wasn’t the case. The average actively managed balanced fund dropped a whopping 28 percent during 2008.6 Why did the average balanced fund manager lose so much money even though 40 percent to 50 percent of their funds’ assets were in bonds? The only explanation is that they were afraid, and they sold stocks when the markets fell. As mentioned in my previous chapter, nobody can predict the short-term movements of the stock markets. Following a disciplined couch potato strategy is likely to be far more profitable than allowing a fund manager to mess with your money.
Table 5.1 The Couch Potato Portfolio vs. the Average US Mutual Fund in 2008
Average US mutual fund –29.1% drop $10,000 dropped to $7,090
Indexed Couch Potato Portfolio concept –20.4% drop $10,000 dropped to $7,960
Another nice thing about using the couch potato portfolio strategy is that (despite the market crash of 2008–2009) you would have still made money from 2006 to 2011. During this five-year period—when many actively managed balanced mutual funds lost money—a $10,000 investment in the couch potato portfolio would have grown to more than $12,521.56. That’s an overall gain of 25.2 percent.7
As an investor, I loved the stock market decline of 2008–2009. But as a consultant, it was disheartening. Many people brought their portfolios to me during the economic crisis, revealing investments that had collapsed 40 percent or more in value.
When I looked at their investment holdings, I found something pretty shocking: their investment advisers obviously had little respect for bonds. Most of the people who showed me their statements were older than me, so they should have had bond components that equaled or exceeded mine. But none did. In some cases, they had no bonds at all! Their accounts fell far further than mine when the markets declined and they couldn’t take advantage of cheap stock market prices because they didn’t have any bonds to sell.
Investors in their 50s and 60s, especially, require bonds in their portfolios. It would be tough to find an investment book that didn’t include this fundamental principle. But many of the accounts I saw were fully exposed to the market’s gyrations without a protective bond component.
I taught with one fellow whom I refer to as a “cowboy investor.” He’s in his mid-50s and won’t have a pension because he spent his career teaching in private schools overseas. He says bonds are for wimps, so he doesn’t own any. Instead, he buys whatever rises in value (after it rises) and he sells whatever falls (after it falls). This gives him the distinction of a cowboy who’ll never have enough money to leave the ranch.
Combinations of Stocks and Bonds Can Have Powerful Returns
Even when stock markets are rising, a portfolio with a bond component isn’t the “party pooper” most cowboy investors think it is. Financial author Daniel Solin notes that from 1973 to 2004, an investor with an allocation of 60 percent in a US stock market index and 40 percent in a total bond market index would have earned an average return of 10.49 percent annually.
An investor taking much more risk and having 100 percent of their portfolio in a stock index would have returns averaging 11.19 percent annually during this period.8
The cowboy investor would have taken more risk, and for what? An extra 0.7 percent annual return? He would have needed a strong stomach. His worst year during this 31-year time period would have seen his account plunge by 20.15 percent. In contrast, an account with 40 percent bonds and 60 percent stocks wouldn’t have fallen further than 9.15 percent during its worst 12 months.9
Using portfoliovisualizer.com, we can see how different Couch Potato portfolios would have performed between 1986 and 2016. The Classic Couch Potato portfolio, 50 percent stocks, 50 percent bonds, would have averaged a compound annual return of 8.04 percent. That would have turned $10,000 into $105,374.
Investors who wished to take a bit more risk may have chosen 60 percent stocks, 40 percent bonds. Such a portfolio would have been slightly more volatile. But it would have earned a higher average return, gaining an average of 8.82 percent during the same time period. That would have turned a $10,000 investment into $116,171.
Those choosing a portfolio with 70 percent stocks, 30 percent bonds would have seen even better long-term results. They would have averaged a compound annual return of 9.16 percent. That would have turned a $10,000 investment into $126,941.
Higher allocations of stocks in the portfolio increase returns over long time periods, as you can see in Table 5.2. But such portfolios fall further when markets fall. And there will always be periods (sometimes years at a time) when bonds beat stocks.
Table 5.2 Couch Potato Portfolios, 1986–2016.
Compound Annual Return
Best Year
Worst Year
$10,000 Would Have Grown to . . .
Portfolio 1 50% Stocks/50% Bonds 8.04%
+27.82%
-15.98%
$105,374
Portfolio 2 60% Stocks/40% Bonds 8.82%
+29.75%
-20.19%
$116,171
Portfolio 3 70% Stocks/30% Bonds 9.16%
+31.67%
-24.39%
$126,941
Source: portfoliovisualizer.com
When Scott Burns first created the Couch Potato portfolio in 1991, he recommended Vanguard’s S&P 500 Index (VFINX) and Vanguard’s Total Bond Market Index (VBMFX). Since then, two other index funds have been introduced that he feels are better. Investors can get broader stock diversification with Vanguard’s Total Stock Market Index (VTSMX). For the bond component, he says investors will have higher odds of beating inflation with Vanguard’s Inflation-Protected Securities Fund (VIPSX).
When B
onds Whip Cowboys
The premise of rebalancing stock and bond indexes doesn’t just work in the United States. It works no matter where you live. MoneySense magazine’s founding editor, Ian McGugan, won a Canadian National Magazine Award for an article adapting the couch potato strategy for Canadians. His method was simple. An investor splits money evenly between a US stock market index, a Canadian stock market index, and a bond market index.
At the end of the calendar year, the investor simply rebalances the portfolio back to the original allocation. If the US stock market index did better than the Canadian index, then the investor would sell some of the US index to even things out with the Canadian index.
If the bond index beat both stock indexes, then some of the bond index would be sold to buy some of the Canadian and US stock market indexes. Of course, if you’re making monthly contributions to the account, you could rebalance monthly by simply buying the laggard—to keep your allocation evenly split three ways.
You can see in Table 5.3 how $100 invested in 1975 would have grown if it were rebalanced annually with equal allocations to the Canadian stock index, the US stock index, and the Canadian bond index. Note that from 1975 to the end of 2015, a combination of bond indexes and stock market indexes wasn’t just “for wimps.” The rebalancing combination of indexes with bonds actually beat the returns of the Canadian stock market index (largely thanks to a strong performing US stock market).
Table 5.3 Invested in the Canadian Couch Potato Portfolio vs. Canadian Stock Index (1975–2015)
Year Canadian Couch Potato Portfolio
Canadian Stock Index
1975 $100
$100
1976 $118
$100
1981 $195
$257
1986 $475
$469
1991 $730
$615
1996 $1,430
$1,134
2001 $2,268
$1,525
2006 $3,163
$2,725
2010 $3,493
$3,157
2015 $5,371
$4,125
Compound Annual Average Return +10.34%
+9.74%
Source: Moneysense.ca (1976–2010 data) Portfoliovisualizer (2010–2015 data, using iShares ETFs, XSP, XBB, XIC)10
Creating a disciplined plan to rebalance a portfolio removes the guesswork from investing, and it forces investors to ignore their hearts. As I mentioned before, we don’t tend to be rational. Most people like buying shares that have risen in value and they like selling shares that have fallen in value.
Smart investors don’t do that. They add money to their investments every month. They rebalance once a year.
If they have a moderate or conservative tolerance for risk, they also add bonds.
Notes
1SPIVA U.S. Scorecard, accessed July 11, 2016, us.spindices.com/documents/spiva/spiva-us-yearend-2015.pdf.
2David Swensen, Pioneering Portfolio Management (New York: Free Press, 2009), 170.
3Paul Farrell, The Lazy Person’s Guide to Investing (New York: Warner Business Books, 2004), 12.
4Scott Burns, “Couch Potato Didn’t Do the Market Mash,” February 2, 2003, Dallas News online, www.dallasnews.com.
5Morningstar data for VTSMX (Vanguard total stock market index) and VGTSX (Vanguard total international stock market index), 2003–2008.
6Scott Burns, “Sloth Triumphs Again,” UExpress.com, February 15, 2009, www.uexpress.com/scottburns/index.html?uc_full_date=20090215.
7“Monthly Self Managed Couch Potato Returns,” AssetBuilder, assetbuilder.com.
8Daniel Solin, The Smartest Investment Book You’ll Ever Read (New York: Penguin, 2006), 63–64.
9Ibid., 63.
10“Couch Potato Performance,” MoneySense online, www.moneysense.ca/2006/04/05/classic-couch-potato-portfolio-historical-performance-tables/; Moneysense.ca (1976–2010 data); Portfoliovisualizer 2010–2015 data, using iShares ETFs, XSP, XBB, XIC.
RULE 6
Sample a “Round-the-World” Ticket to Indexing
Index funds have boarded ships and airplanes to find happy homes outside of the United States. In this section, I’ll give you examples of how to build a portfolio of index funds whether you live in the United States, Canada, Great Britain, Australia, or Singapore. Feel free to check out the section relating to your geographic area, or read with interest how our international brothers and sisters can create indexed accounts. Even if you live in a country not mentioned here, as long as you have the ability to open a brokerage account in your home country, you can build a portfolio of indexes.
This chapter shows how to invest on your own. Going solo is the cheapest (and potentially most profitable) way to invest in index funds. It’s simple. But if hell has to freeze before you go solo, you’ll prefer the next chapter. It describes how to get help through a financial advisory firm.
Still with me? Great! Before getting into the profiles of some real people and how they’re investing, let’s answer a few important questions.
What’s the Difference between an Index Fund and an ETF?
Index funds and ETFs (exchange traded funds) are like identical twins in the same royal family. If they wore t-shirts they would say “Same Same” on one side, “But Different” on the other. They each contain stocks that track a given market. For example, the Vanguard 500 Index fund (VFINX) is an index fund that holds 500 large American stocks. It’s available to Americans who open an account with Vanguard. There are no commissions to buy or sell it.
Each trading day, stocks fluctuate. Anyone buying an index fund can place an order to purchase such a fund. They pay the closing price at the end of the trading day.
ETFs are different. They trade on a stock exchange, much like individual stocks. Theoretically (although this would be foolish) a trader could buy and sell them throughout the day. An ETF, like Vanguard’s S&P 500 ETF (VOO) would earn almost the same return as Vanguard’s 500 Index Fund (VFINX) because it holds the exact same shares in the same proportions. How could returns differ? Vanguard’s 500 Index Fund (VFINX) has an expense ratio of 0.16 percent per year. Costs drop to 0.05 percent per year when the investor has more than $10,000 invested in the fund.
Vanguard’s S&P 500 ETF (VOO) has an expense ratio cost of 0.05 percent, regardless of the amount invested. In theory, investors with less than $10,000 to invest would have a slight cost edge if they bought the S&P 500 in its ETF form.
But ETFs Have Drawbacks
In most cases, investors must pay commissions to buy and sell ETFs.* If they regularly purchase ETFs with small monthly sums, they may pay more in costs (thanks to commissions) than they would with a regular index fund.
Also, most stocks pay cash dividends. When an ETF receives those dividends, the dividends may or may not be reinvested automatically for free. It may depend on the brokerage used. With traditional index funds, however, dividends can be reinvested automatically at no extra cost.
The American Dream Lives With Index Funds
The United States still leads the global pack when it comes to index fund offerings. Investors with relatively small sums can buy index funds through Vanguard. Such costs rival those of the cheapest ETFs. Non-Americans have
different options. In many cases, they can also buy index funds. But they cost more than their US-based cousins, or they carry higher minimum investment requirements. Low-cost ETFs, however, are globally available. Investors can purchase them off any of the world’s stock market exchanges. Here are the steps to buying one.
How Do You Buy an ETF?
An ETF that tracks the entire global market is an excellent choice. Most of the model portfolios that I’ve listed later in the book include such a product. It would include stocks from each of the world’s geographic regions. Its weightings are usually broken down into something called global market capitalization. For example, the US stock market makes up nearly half of the total worth of all global stocks. That’s why a global stock ma
rket ETF would have nearly half of its exposure in US stocks. Other countries’ stocks would also be represented based on their global market capitalization.
Investors could buy a Global ETF from any variety of different stock exchanges. Whether an investor buys an ETF off the US stock market, UK stock market, Australian, Canadian, or virtually any other market, the process is similar.
Step 1: Open a Brokerage Account
The first step is to open a brokerage account and send cash into that account.
Step 2: Identify the ETF symbol
If you want to buy an ETF, you need to identify the ticker symbol representing such a product on that given stock exchange. Table 6.1 lists some ETF ticker symbols for global stock market ETFs.
Table 6.1 Sample Global ETF Ticker Symbols
Stock Exchange ETF Name ETF Symbol
Annual Expense Ratio
US Vanguard Total World Stock ETF VT
0.14%
Canadian Vanguard FTSE Global All Cap ex Canada Index ETF VXC
0.25%
UK Vanguard FTSE All World UCITS ETF VWRL
0.25%
For example, Americans would buy the ETF that trades on the US stock exchange. Its symbol is VT. Canadians would buy the ETF that trades on the Canadian stock exchange. Its symbol is VXC.