I want to get into index funds but don’t know which ones to buy. Any advice?
I used to roll my eyes and groan audibly when my dad answered what I thought was a simple question with a long, complicated answer. He’d always include some historical context, a political angle and up to the minute scientific research. I have heard that we all, one day, become our parents and I think it is now happening to me. Your simple question—which index funds should I buy?—has become a three part series. Whoops.
Butter tarts are not all about butter
I used butter tarts as an example in my last blog and I’ll continue that analogy here. Butter tarts have very few ingredients and each plays a different role: sugar to make them sweet, butter to make them creamy and a pastry shell to hold it all together. Lots of recipes call for butter and sugar, but the quantity of each depends on what you’re baking. The same approach works for investing. The quantity of each investing ingredient in your portfolio depends on what you’re saving for: retirement, your kids’ education, the down payment on a house, etc.
Whether you choose to go with index funds or ETFs, you’ll start with four basic ingredients: fixed income, Canadian equity, U.S. equity or global equity.
Fixed income equals your age
When investing for retirement, the rule of thumb suggests the amount of fixed income in your portfolio should equal your age. So if you are 40 years old, then 40% of your portfolio should be in fixed income. The rest of this super simple portfolio would be divided equally among the remaining three equity products—Canadian, U.S. and Global. That would give you a portfolio that looks like this:
|Sample $10,000 portfolio|
The Canadian Couch Potato has other model portfolios that you can look at depending on how detailed you want to go. There is no one size fits all, but this is a good place to start when it comes to retirement.
Goal: Saving for education
Become more conservative over time
If you are saving for your kids’ education, the amount of each product in your portfolio will be different than the allocation you would use to save for retirement. There are two reasons for this: time horizon is much shorter and the amounts are smaller. With retirement savings you might save for 40 years until you turn 65 and then withdraw money from your portfolio gradually over the next 20 years. That time horizon allows you to weather the ups and downs of the stock market. But when it comes to education you might start saving when your child is born, at best. That means you have only about 17 years to save before that money starts to get withdrawn. And unlike retirement, the money is withdrawn quickly, typically over a period of just four years.
Likewise, when you are saving for retirement you are likely contributing a fair chunk of change into an RRSP. The amount will vary depending on your income, but lets say you plan to save $10,000 a year in an RRSP to really make it worthwhile. RESPs don’t work this way. To make the most of the RESP and the associated government grant, you’d only put in $2,500 a year.
The quantity you invest in the various ingredients also changes as your child ages. You might start fairly aggressively when your child is very young, going as high as 100% in equity and [focus only on Canada] [insert Bruce post on the CDZ as one great ETF for RESP] because the amount you have to invest is quite small. As your child gets older you would shift the RESP makeup towards fixed income to lower your risk and add in other types of equity, like U.S. and global. By the time your kids need the money, you might be fully invested in fixed income. You would be best to make the changes gradually as you add new money into the portfolio. Here is a simple illustration:
|Sample RESP portfolio makeup according to age|
|Age 0-5||Age 5-13||Age 13-18|
(Click here for more insight on RRSP investing strategies.)
Goal: Down payment
Low, low risk is best
If you are saving for the down payment on a house, you might want to consider an uber conservative approach. That means that 100% of your portfolio would likely be in fixed income to avoid the volatility on the stock market. You might simply put your down payment into a high interest savings account, or buy GICs in a tax-free savings account.
Other factors that may tweak your percentages
There are some of the other factors that might have you diverge from the percentages above. For example, if you have a very high tolerance for risk—perhaps you have a spouse with a full pension so you’re less concerned about stock market volatility—you might increase the level of equity you hold in your retirement savings. And vice versa, if your risk tolerance is low, you might increase the level of fixed income you hold.
You might also structure your portfolio differently depending on the market environment. Let me be clear, I’m not a big fan of trying to time the market—that is, trying to determine if stocks are going to rise or fall. It is very tough to do effectively and in my opinion, just a waste of time [insert link – Why I Have No Faith in Market Timing]. But some people try to do it, and so they might have different percentages based on where they think the market will go. People who take this approach might choose to have a lower allocation in fixed income and much more Canadian equity if they believe that stocks here at home are positioned to rise.
One last word
The “S” in “Sellery” stands for simplicity. Determine what your investment objective is, develop a basic plan for it, and then execute well on that plan, keeping your MERs low. Then go out a enjoy life. Now if you’ll excuse me, I have to go light the barbeque.