A Beginner’s Guide To Index Investing

What you need to know about index investing

If you’re like many Canadians, you own a wide mix of actively managed funds that invest in a variety of market sectors. And, of course, you’re hoping to beat the market more often than not.

Truthfully, the odds of that happening over the long run seem fairly slim. But, if you’re going to try, at least try to get the odds in your favour. Don’t think in terms of whether you can or can’t beat the market. Instead, ask yourself: “Do I really need to?”.

Do You Really Need To Beat The Market?

Diligent savers, for instance, may not need to beat every fund manager in sight. For them, being close consistently should be enough. If earning what the market produces – in other words, buying the index – gets you to where you need to be, why subject yourself to the hassles of trying to do more?

The problem with many big managed funds in Canada is that much of what you’re paying for isn’t always stock-picking skill, but basic market exposure – and you can get that for a lot less by buying market-tracking index or exchange traded funds.

Even with a well-run fund, you’re going to get the underlying market’s annual performance, plus or minus a couple of percentage points. Factor in the fees and the majority of funds really start to lag.

Factor In Fund Costs

You see, investing would be a zero-sum game if no costs were associated with trying to beat the market. But, since there are actually lots of costs, active investing is really a negative-sum game. The very act of joining in reduces the amount of money to be divided among the various players.

So, why doesn’t everyone go the cheaper passive route? Well, it’s often because they want to own a portfolio, not just a fund. And putting the right funds together in some sensible fashion isn’t always the easiest thing to do.

Look At Low Cost Index Funds

Enter paint-by-numbers portfolios – otherwise known as Couch Potato, Easy Chair or Lazy Investor strategies – where the idea is to keep things simple, flexible, and as inexpensive as possible. Here are a couple of examples.

Bill Schultheis, a former broker and the author of The New Coffeehouse Investor: How to Build Wealth, Ignore Wall Street, and Get on with Your Life launched his straightforward Coffeehouse Portfolio 20 years ago.

His solution for a balanced portfolio: Put 40 per cent of your money in an intermediate-bond index fund and 10 per cent in each of six equity funds, rebalancing once a year to the original mix.

Keeping Things Simple

Back when he started, you would have been limited to using only index funds but now with the advent of much cheaper exchange traded funds, there are even more options to string together. Here’s what he came up with.

–          40 per cent Bond Market Index

–          10 per cent S&P 500 Index

–          10 per cent Large-Cap Value Index

–          10 per cent Small-Cap Index

–          10 per cent Small-Cap Value Index

–          10 per cent International Stock Index

–          10 per cent REIT Index

Adding In A Canadian Flavour

A bit too American for you? Then consider the Complete Couch Potato portfolio, developed by Dan Bortolotti, author of The MoneySense Guide to the Perfect Portfolio. His partially made-in-Canada asset mix – using ETFs exclusively – is 40 per cent bonds, 50 per cent stocks, and 10 per cent in real estate.

To his way of thinking, the optimal mix for Canadians looks something like this.

–          20 per cent Canadian equity

–          15 per cent U.S. equity

–          15 per cent International equity

–          30 per cent Canadian bonds

–          10 per cent Real return bonds

–          10 per cent REIT

True, neither of these approaches has shot the lights out. But, when you compare their results to what the average balanced fund has accomplished, then the numbers start to make a lot more sense.

 

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One thought on “A Beginner’s Guide To Index Investing

  1. Too true, a simple portfolio like outlined with low costs might well result in superior returns. As you say ETF’s offer a great way to get into index investing. You Canadians are lucky with the development of corporate class ETF’s which can reduce your costs down even further, nothing like that here in Oz unfortunately

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