John and Mary Braun’s story is all too common. Twenty years ago when they started investing, they wanted to make absolutely sure they saved up enough for retirement, so they sought out the advice of not one, but two financial advisers to make sure their investments were on the right track.
Now, two decades later, the Brauns are in their 50s, and after all those years of pricey expert help, you would expect them to have a finely tuned portfolio with just the right risk level, the right mix of assets and at least average returns. Instead, they have a portfolio mess of 35 mutual funds with six different investment companies. They are 90% in stocks—way too high for their risk tolerance and time horizon—and as a result, they were devastated by the market crash of 2008. In fact, not counting new contributions, the Brauns now have less money in their portfolio than they did five years ago. Shockingly, for this lacklustre performance, it turns out they were paying more than $17,000 in fund management fees every year. “We’re really quite embarrassed by it all,” says John, 53, an office manager in Ottawa. “And that’s sad because we really tried to do the right thing. No debt, regular monthly investments into whatever mutual funds we were told to invest in. But what did that get us? A mishmash of equity funds with high fees and a sea of contrary advice.”
The Brauns (whose names we’ve changed to protect their privacy) are worried because even though they have a healthy $736,000 in their nest egg, they don’t feel in control of their money, and they have less than 10 years to go before they retire. “You’d think people in our financial position would be able to sleep better,” John says, “but we are starting to wonder about whether we are getting the best advice from our current advisers—who get paid regardless of whether our funds go up or down.”
Frustrated and anxious, a few months ago John emailed us here at MoneySense to ask if there’s a better way to invest. Luckily, it turns out there is. It’s called the Couch Potato portfolio, and it’s a simple, safe way to invest on your own that beats most mutual funds. The fund fees are about one-tenth of what most mutual fund investors are paying now, and it only takes 15 minutes a year to set up and maintain. We decided to show the Brauns how they could benefit from switching to the Couch Potato, and along the way, we’re going to show how you could switch too. Then we’re going to enlist experienced financial planner Norbert Schlenker, president of Libra Investment Management on Salt Spring Island, B.C., to answer some of the common questions that the Brauns and others have about making the transition.
The Couch Potato portfolio is based on the simple fact that the market is smarter than any one individual, even your adviser. So rather than paying someone a lot of money to try to beat the market, when you invest in the Couch Potato, you invest in the market itself. Why is this a good idea? Because the overall market, as measured by the market index, beats the performance of almost all actively managed mutual funds. This was proven yet again by recent figures released by Standard & Poor’s for the five-year period ending Sept. 30, 2009. They found that even through the worst market crash in decades, the S&P/TSX composite index outperformed 94% of actively managed Canadian Equity funds. By investing in index funds, you can harness that index performance for yourself, and even after you subtract the index fund fees, the result is a portfolio that, over time, will likely beat more than 80% of the money managed by professionals.
To assemble a Couch Potato portfolio, you simply invest in a small group of low-cost index funds (also called exchange-traded funds, or ETFs). These funds charge rock-bottom fees because there is no fund manger making decisions on which stocks and bonds to include. Instead, the funds rise and fall in tandem with their associated indices. For example, the iShares CDN Composite Index Fund (XIC) gives you roughly the same return you’d get if you bought up the stocks in the S&P/TSX Capped Composite Index, while the Claymore Canadian Fundamental Index ETF (CRQ), gives you the same return you’d get if you invested in the FTSE RAFI Canada Index.
Because each index fund gives you the effective return of owning dozens of stocks, a simple portfolio of just three or four funds delivers more diversification than most mutual funds. But more importantly, you get that diversification for a rock-bottom fee. Right now, for instance, the Brauns are paying an average of 2.4% of their assets each and every year to invest in actively managed mutual funds. But you can become a Couch Potato for a fee of just 0.5% a year or less. The two percentage point difference in fees makes a bigger difference than you might think. It could be the difference between getting a 5% a year return, and getting 7%. When you take compounding into account that can add up to hundreds of thousands of dollars over time.
When we looked at how switching to the Couch Potato would affect the Brauns’ performance, its strengths became clear. Given their $736,000 portfolio, we found that John and Mary Braun would save almost $14,000 in fees by switching to the Couch Potato this year alone. Their annual savings would be enough to buy a nice new car every two years. Over a few years, assuming they reinvested those savings, the difference would grow and grow, as their money compounds.
When we ran the arguments for switching to the Couch Potato past the Brauns, they were intrigued. John had heard about the strategy before and was enthusiastic, but Mary was a bit unsure about making the switch. She had several concerns, which are listed in the Q&A below. Her main worry was the idea that they would have to look after their investments on their own, without a professional to turn to for guidance. “We crave less complexity,” Mary told us. “But I’ll come out and admit it: sometimes I feel like we don’t have the expertise to do this on our own.”
If that concerns you too, we have good news. You don’t have to do it on your own. If you want, you can enlist the help of a fee-only planner, whom you can pay by the hour to advise on what kind of Couch Potato portfolio is right for you and how to make the transition (see a list of fee-only planners). If you’re still unsure, you could simply ask a fee-only planner to calculate how much you would save in fees if you switched. When we asked top financial planner Norbert Schlenker to do that for the Brauns, he found that over the next 20 years, they would pay an astounding $400,000 to $500,000 in mutual funds fees if they kept things the way they were. Using the Couch Potato portfolio, they would pay only $20,000 to $50,000. That means a savings of at least $350,000.
When we told the Brauns this, it was a big eye-opener. Their mutual funds would have to perform a lot better than the Couch Potato portfolio to make up for such a huge difference in fees. They decided that they would go ahead and convert at least some of their holdings and give the Couch Potato a try. So we asked Schlenker to draw up a step-by-step plan for making the transition. “Deciding to become a Couch Potato is easy,” says Schlenker. “But converting to a Couch Potato portfolio, like the Brauns want to do, can be an administrative challenge.” Here’s how to make sure you get it right:
Step 1: Decide what can be converted
To start, Schlenker analyzed each of the Brauns’ accounts to see which ones should be converted to the Couch Potato and which shouldn’t. It might not make sense to convert accounts that are smaller, will only be held short term, or which hold mainly GICs. As well, it may be impossible to convert company plans where you don’t have access to index funds. In the case of the Brauns, Schlenker decided not to convert the registered education savings plans (RESPs) for their daughter Michele, 20, and their son Peter, 17, because both of these accounts will be drawn down soon and should be in short-term fixed income investments. Schlenker also omitted the investments inside Mary’s defined contribution RRSP plan at work, as he wasn’t sure what funds she had access to in that account. Schlenker decided that the Brauns should concentrate their efforts on their two RRSPs and their three taxable investment accounts. Altogether, the accounts that could be transitioned to the Couch Potato add up to about $530,000, two-thirds of which is taxable, and one third of which is tax sheltered in RRSPs.
Step 2: Choose an asset allocation
Part of the problem with the Brauns’ investments is that when you have 35 different mutual funds, doing routine analysis to ensure you have the proper asset allocation becomes difficult. The danger is that because the task seems overwhelming, it’s not done at all, which can lead to skewed allocations or unintentionally high risk levels. That was indeed the case with the Brauns, Schlenker found. He discovered that their total portfolio is close to 90% equities, which is way too aggressive.
Before you switch to the Couch Potato, you should decide what allocation is right for you. A good rule of thumb is that the percentage of bonds in your portfolio should be close to your age. So if you’re 40, you should have a portfolio that is roughly 40% bonds and 60% stocks. No matter how aggressive or conservative you think you are, Schlenker advised that you do not go below 25% or above 75% bonds. Write down what you’ve chosen as your asset mix and why you’ve chosen it, then keep for future reference.
Step 3: Consider taxes
Schlenker found that little attention had been paid to tax efficiency in the Brauns’ investments. Their only bond fund was in a taxable account, but as a rule, bonds and other income-producing investments should be in tax-deferred accounts such as RRSPs where possible, because interest income from bonds is taxed at a higher rate than the capital gains and dividends you get from stocks. You might want to keep that in mind before designing your Couch Potato account. If your retirement savings are partly in RRSPs and partly outside RRSPs, you may want to put the bond portion of the Couch Potato inside the RRSP.
Step 4: ETFs or index mutual funds?
For those who have already accumulated considerable funds—at least six figures—exchange-traded funds (ETFs), which cover broad asset classes, are preferred because of their low expense ratios. That’s what Schlenker recommended for the Brauns. Those with smaller nest eggs may want to use index mutual funds, which act like ETFs, but are constructed as low-fee mutual funds, so you can make regular contributions at no cost. Schlenker says the best bargain in Canada nowadays for index mutual funds is TD’s e-Series of funds, which are only available through accounts held at TD Canada Trust.
Step 5: Open a discount brokerage account
If you don’t already have one, you should open a discount brokerage account and transfer all of your current mutual funds into that account. If you plan on using the TD e-Series index funds, you’ll want to open a TD Waterhouse discount brokerage account. (If you don’t want to open a TD Waterhouse account, but you still want index mutual funds rather than ETFs, you could look at the pricier RBC Index funds, which can be held in any account.) If you’re going the ETF route, you can open any discount brokerage account you wish. You can find a list of discount brokerages on our website at MoneySense.ca (click on the “Couch Potato” menu item under “Investing”). If you have both RRSP and non-RRSP savings you will have to open at least two accounts, one that’s registered as an RRSP account and one that isn’t. For the Brauns, Schlenker recommended that they open three accounts—one RRSP account for John and one for Mary, plus one joint taxable account.
Step 6: Sell your mutual funds
Once all your funds have been transferred into your discount brokerage account, you’ll need to cash them in. But be aware that there could be complications. The Brauns are lucky because none of their current investments have deferred sales charge (DSC) penalties. That means they won’t be charged a fee if they sell their mutual funds before holding them for a full six years. But if your funds do have DSC penalties, you could incur big fees for cashing out of the funds early. To find out if you’ll incur DSC penalties for selling, call the adviser who sold the funds to you.
Step 7: Pick your Couch Potato
Now you have to decide which Couch Potato portfolio is right for you. The simplest all-purpose version is the Classic Couch Potato. It’s a good portfolio to start with, as it’s the easiest to set up and manage, and it gives you a classic 60/40 split between stocks and bonds. The Global Couch Potato provides more exposure to European and Pacific stocks, which adds more diversity and could lower your volatility over the long term. The High-Yield Couch Potato is best reserved for those with high risk tolerances and long time horizons, or those who have a good portion of their savings in a pension plan. The Conservative Couch Potato might be a good pick if you’re getting a bit closer to retirement and you want a more defensive portfolio. The All-Dressed Couch Potato may appeal to more advanced index investors who are willing to spend more time tinkering in return for the extra diversification.
For the Brauns, Schlenker suggested the Classic Couch Potato mix of one third fixed income, one third Canadian equities and one third U.S. equities. In their case, the portfolio could be implemented easily and tax efficiently by investing their fixed income portion inside their RRSP account, and the equity portion in their non-registered investment accounts. If your retirement savings are entirely within your RRSP, then implementing the Couch Potato is even easier—you just put the whole portfolio inside your RRSP.
If you’re using ETFs, you can find the ticker symbols for each portfolio listed in “Pick your Potato”. To assemble the portfolio you want, wait for your mutual fund sales to settle (which could take up to a week), then divide up the total amount of cash you are investing according to the percentages given in the table. All you have to do then is log into your discount brokerage account and buy the appropriate ETFs just as if they were stocks. You will likely be charged a commission of about $20 or $30 for each purchase.
Step 8: Rebalance annually
After your portfolio is assembled, you can kick back and relax. The only maintenance you need to do is to take 15 minutes once a year to buy and sell the funds in your Couch Potato portfolio to get back to your original fund allocation. This forces you to buy a little when things look black and sell a little when the good times roll, which can increase your returns over the long haul.
What kind of returns can you expect? No one knows what the markets will do over the next few decades, but we can tell you that our Classic Couch Potato portfolio has generated 10.6% annual returns over the past 33 years. That means that if you invested $100,000 in the Classic on January 1, 1976, it would be worth $3,094,810 as of December 31, 2009 (for year-by-year returns, go to MoneySense.ca and click on the “Couch Potato” menu item under “Investing”). Compare the Potato’s results to what the average actively managed mutual fund has accomplished over time periods of 25 years or more and we think you’ll be impressed. The Brauns certainly were.
Mary’s Couch Potato Q&A
Mary Braun had some concerns about switching to the Couch Potato, so we asked top financial planner Norbert Schlenker to address each one. You may find that you share the same concerns.
I have an adviser and even though our returns have been poor, he’s the professional right? Shouldn’t we stick with him?
There are many excellent financial advisers out there, and they can play an important role in planning your successful financial future. They can give you a sober second opinion when
the markets crash, and act as a sounding board for investing ideas. However, you may want to ask your adviser to show you how your current portfolio is faring compared to a portfolio of appropriate benchmark index funds. You should also ask about the total fees you are paying to the adviser and the mutual fund companies each year, and find out what your overall asset allocation is. If you don’t like the answers you are getting, you may want to consider the Couch Potato.
Our adviser is a good friend. Switching to the Couch Potato isn’t worth losing a friend over is it?
If you’re not happy with your performance, you should be open and straight with your adviser and tell him or her that your needs are not being met and you are opening a discount brokerage account and investing the Couch Potato way. Explain to your adviser that with lower fees and some research under your belt, you feel you can do a good job of managing your own money.
If you really want to maintain the relationship, offer to pay $1,000 to $2,000 per year directly to your adviser to help you assemble and rebalance your Couch Potato portfolio. If that meets with resistance, draw your own conclusions about what the friendship means to the adviser. In the Brauns’ case, Schlenker’s opinion is that paying an extra $10,000 a year in fees is a very steep price to pay for friendship.
We’re not money managers. We can’t do any better on our own than an adviser who has had years of training, can we?
With the Couch Potato you really aren’t on your own. You’re enlisting the help of not one, but thousands of fund mangers who are constantly scouring the market looking for bargains to buy and overpriced stocks to sell. Thinking that you or your fund manger can consistently outperform all of those thousands of other professionals isn’t rational. History shows us that over long periods of time, very few investment gurus, such as Warren Buffett, can pull that off. So the thinking behind the Couch Potato approach is that you just buy the market itself, and harness all of the work those thousands of fund mangers are doing for a dirt-cheap fee.
We’re really busy and we’re afraid it will be complicated and require a lot of time. Am I right?
The Couch Potato strategy is basically a “set it and forget it” strategy. The Brauns are right to want to simplify their investments. But they’re wrong if they think it will be complex and require a lot of time. Probably the most time-consuming part will be untangling their current mess of mutual funds. Once everything is in cash, you can assemble a Classic Couch Potato Portfolio in about 15 minutes. It takes as much time as buying three stocks. After that, you only have to rebalance your portfolio back to the original allocation once a year. The result is a very resilient portfolio. Even if you forget a year by accident, it’s not that big a deal.