Couch potato portfolio: Introduction
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Everything you need to know about the couch potato strategy — and how to get started building a couch potato model portfolio.
Here at Money.ca, you’ll often see us refer to “couch potato investing.” As you may have gathered, this low-cost, simple — and smart — investment strategy has nothing to do with either living room furniture or root vegetables. Rather, a couch potato portfolio can help you achieve your investment goals while taking on minimal risk.
Want to know what all the fuss is about and how to get in on the action? Here’s your cheat sheet for all things couch potato.
What is the couch potato strategy: Introduction
Back in the 1990s, a financial columnist for The Dallas Morning News named Scott Burns used the concept of passive investing to create a super-simple way for investors to earn solid returns over time, with almost zero effort. So little effort, in fact, even a lazy couch potato could pull it off.
So, what’s passive investing? In a nutshell, it refers to a style of investing that eschews the pursuit of “winning” companies or assets intended to “beat” overall market returns, since very few individuals or advisors can successfully pick and choose investments that outperform the market consistently over time. (We’ll get into more detail on active fund managers’ success rates, or lack thereof, below.)
Instead, passive investors try to match total market performance by putting their money into low-fee funds, such as index funds and exchange-traded funds, which hold all (or nearly all) the stocks or bonds in a particular index.
Burns’ idea was to boil down a passive approach to its essence, creating a portfolio of just two (equally divided) investments:
- an index fund of U.S. stocks (one that tracks the S&P 500, which means the fund contains the 500 largest U.S. stocks); and
- an index fund of U.S. bonds (which similarly tracks the U.S. bond market).
By doing this, investors would have their money in a balanced array of U.S. stocks and bonds that’s diversified by industry, since each index is made up of all the companies in that market, not just a few supposed “winners.” Burns felt this portfolio would provide a close approximation to overall market performance, but also be relatively safe. If the stock market tanked, the bonds would still perform well and vice versa.
Once a year — and only once a year, he said — investors should check to see which of the two funds is worth more and sell some of it off to buy the other. If, for example, the bonds were worth more than 50% of the portfolio, investors should sell off some of the bond index fund (selling high) and use that money to buy more of the stock index fund (buying low) to get back to an even split.
What’s the “Canadian couch potato”?
About 10 years after Burns published his couch potato portfolio, MoneySense magazine introduced local investors to the Canadian couch potato, popularized by finance writer Dan Bortolotti.
It’s similar to the original couch potato portfolio but adds slightly more diversification by adding international equities to the mix. The Canadian couch potato portfolio is made up of low-fee index funds or ETFs that track the following markets:
- Canadian stock market index
- International/U.S. stock market index
- Canadian bond market index
How you divvy up your portfolio — say, a third in each fund, 25%/25%/50%, or any other allocation — depends on your comfort with risk and investment time horizon.
Since stocks are riskier than bonds but offer the potential of higher returns, those with lots of time to let their money grow (and lots of time to recover from short-term setbacks) can usually be more heavily invested in stocks. (For more advice on investing for the long run, check out Money.ca's best long-term investment strategies.) Short-term investments, on the other hand, should be weighted more heavily toward bonds to minimize risk.
Why is the couch potato the best approach for investing?
Canadians pay some of the highest fees in the world — 2% to 3% of their total portfolio annually — for actively managed mutual funds, betting that their fund manager will be some kind of “market whisperer” who can deliver high returns. And maybe some do, some of the time.
But the data is clear that most actively managed mutual funds in Canada don’t perform well over the long run. For the 10 years ending in 2017, for example, less than one-quarter of the country’s actively managed Canadian equity funds outperformed their respective benchmarks; just 6% of Canada’s actively managed international equity funds delivered higher than market returns, and less than 2% outpaced the S&P 500. (The period ended with a thud in 2017 when not a single Canadian fund manager investing in U.S. stocks delivered higher returns than the S&P 500 index.)
Even when actively managed mutual funds do match or have better market performance, investors may never receive those additional earnings because the fund manager takes such a sizable cut off the top.
So, you have a choice:
- Pay fees of 2% to 3% for actively managed mutual funds that will probably fall short of market performance over the long run; or
- Pay a fraction of a percent in fees for passive funds that are designed to match market returns.
It doesn’t take a genius to see that the second option — the couch potato portfolio — is the smarter choice. By paying less in fees, investors maximize their annual returns which compound over time.
How do I become a couch potato investor?
Canadian investors who want to go the couch potato route have several options:
- Open an account with an online discount brokerage, such as Questrade, so you can buy low-fee ETFs
- Open an online investment account so you can buy low-fee index funds, such as Tangerine Investment Funds or TD’s e-Series indexes
- Open an account with a robo-advisor, such as Wealthsimple, so you can choose a pre-fab portfolio of ETFs that matches your risk profile
Each of these options has its pros and cons, as we’ll examine below.
Online brokerages vs. online investment accounts vs. robo-advisors: How to choose?
Obviously, if you enjoy cooking, you’re good at it and you have the time, you’ll be happier with a DIY approach than someone who can’t even make toast without burning it or who is barely home long enough to open the fridge door.
The same goes for investing — if it’s your thing, you might prefer to do it all yourself with an online brokerage account and pay the lowest fees. If you’re cool with making a few choices on your own and manually re-balancing once a year, but don’t want to make investing your hobby, a self-directed portfolio of index funds can still be a good low-cost option. If you want the ease of a ready-made slate of index funds or ETFs, you will pay for that convenience — how much you pay depends on the service and funds you choose.
(To extend the metaphor even further, you could say actively managed mutual funds are like chi-chi restaurants with valet parking, celebrity chefs and outrageous menu prices to match.)
Here are some guidelines on how to choose the best couch potato investing option for you.
Go with an online brokerage (such as Questrade) if you:
- Want to pick your own customized portfolio of ETFs and asset allocation
- Can perform all the transactions manually
- Have a larger portfolio
- Make lump-sum, infrequent transactions (as each stock trade or ETF sale charges a small commission)
- Want the lowest management fees (around 0.15%)
- Are interested in additional asset classes, such as emerging markets, real estate or socially responsible investments
- Are willing and able to rebalance your portfolio once a year
- Have nerves of steel when it comes to market fluctuations (i.e., you aren’t tempted to make emotional investment decisions when markets fall, which can negatively impact returns)
Go with an online investment account of self-direct index funds (such as TD’s e-Series funds) if you:
- Don’t want to do full DIY trading with a brokerage fund
- Are happy to choose three or four index funds (and asset allocation) from a limited selection
- Want to set up automated transactions
- Have a small or large portfolio
- Make smaller, more frequent contributions (no trade commissions)
- Want lower management fees (around 0.3% to 0.5%)
- Are content with basic asset classes (stocks and bonds)
- Are willing and able to rebalance your portfolio once a year
- Have nerves of steel when it comes to market fluctuations (i.e., you aren’t tempted to make emotional investment decisions when markets fall, which can negatively impact returns)
Go with a robo-advisor if you:
- Don’t want to choose ETFs or index funds on your own or determine asset allocation; would rather have a set portfolio that matches your risk tolerance
- Want to set up automated transactions
- Have a small or large portfolio (depending on the provider you choose)
- Make smaller, more frequent contributions (no trade commissions)
- Want low management fees (around 1% or lower)
- Are interested in additional asset classes, such as emerging markets, real estate or socially responsible investments (excludes Tangerine index funds, which offer only basic asset classes)
- Don’t want to worry about re-balancing once a year
- Need the structure of an automated account to keep you from making emotional investment decisions that can negatively impact returns
- May want some financial planning services
Online brokerages & robo-advisors comparison chart
What can I invest in?
You can do the couch potato strategy in pretty much any investment vehicle that would normally hold mutual funds. That includes registered retirement savings plans (RRSPs and spousal RRSPs), registered education savings plans (RESPs), registered retirement income funds (RRIFs), locked-in retirement accounts (LIRAs), non-registered accounts, corporate accounts, and, yes, tax-free savings accounts (TFSAs)!
TFSAs confuse many investors because (a) it’s a relatively new product that was introduced less than a decade ago; and (b) “savings account” is in the name, which makes it sound like a TFSA can only be a type of bank account. This couldn’t be farther from the truth.
While you certainly can keep your TFSA in a regular savings account earning about 1% interest, which might be a good strategy if you expect to make lots of withdrawals, it doesn’t make much sense as a medium- or long-term investment strategy. (Similarly, there are RRSP savings accounts, but few savvy investors will park their money there for any prolonged period of time.)
If you put your TFSA savings into a couch potato portfolio of index funds or ETFs and leave it to grow, you’ll really make the most of those tax-free, compound returns. And, unlike RRSPs, you pay no tax or penalties when you take the money out. We put together a more detailed look at how to invest in your TFSA.
Why you should build a strong couch potato portfolio
Can such a simple strategy really let me achieve my financial goals? The answer is: yes! If you are a conscientious saver and invest those savings in a balanced and diversified low-fee couch potato portfolio that matches your risk tolerance, you will see solid returns over time. It’s a no-brainer.
In the past 30 years, for example, even Burns’ basic 50% U.S. stock/50% U.S. bond couch potato portfolio would have delivered compound annual returns of 7.73%, beating the average U.S. annual inflation rate over the period (2.56%) by more than 5% (see chart below).
Couch potato performance (1988-2018) vs. inflation
The bottom line? Get your spud on now
The couch potato approach is a proven low-maintenance strategy that gives investors close-to-market performance while paying very low fees.
So, unless you have a very large sum of money to invest or your financial situation is very complicated (say, with various tax considerations), it’s unlikely a full-service advisory firm can offer you more than the humble spud.
All you have to do is choose your style (DIY or hands-off), pick a provider (discount brokerage, online investment account or robo-advisor), figure out your asset allocation (or choose one from a pre-fab selection) and start investing to see your wealth grow.
Out of all the online brokerages in Canada, our top pick is Questrade. Their rock-bottom low fees, user-friendly online trading program, and excellent customer are hard to beat.
For robo-advisors, our top choice is Wealthsimple, as their fees are highly competitive and customer service is second to none. We can’t help but love their sleek, easy-to-use online platform that’s easy to use.
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