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.

The next step: Do the Couch Potato