Couch Potato Portfolio

Editor's note : from http://www.canadianbusiness.com/

By Duncan Hood and Ian McGugan

We call our approach the Couch Potato strategy. It's based on the simple fact that the market is smarter than any single individual. If the market says a stock is worth $20 a share, chances are the stock is probably worth somewhere close to $20 a share.

This may surprise you. Most market commentary is geared to making you believe that there are scads of undiscovered bargains out there. But think about how the world works and you realize how unrealistic that proposition is.

On any given day, thousands of highly paid, highly competitive mutual fund managers and pension fund experts are scouring the market looking for bargains. When they think a stock is undervalued, they buy it. All that buying forces up the price of the stock until it's trading for what most investors believe is fair value. Similarly, if the pros believe a stock is overvalued, they sell it and keep on doing so until the stock meets their definition of fair value. Thinking that you're going to beat the system and turn up lots of great, undiscovered stocks is a bit like thinking you can wander into a thoroughly explored wilderness and spot a gold mine that all the professional geologists just happened to overlook.

The best proof of the market's intelligence is that even the professionals can't keep pace with it. Over any period of a few years or more, about 80% of actively managed mutual funds lag behind the market. They're weighed down by the salaries of their managers, by research costs, by marketing expenses, by fees paid to financial planners, by trading expenses.

Here's where the Couch Potato strategy comes in. It's based on a simple idea: if active management doesn't beat the market, why not dump it and buy the market instead?

You buy the market by investing in a small collection of low-cost index funds. These funds passively follow the ups and downs of market indexes, such as the S&P/TSX Composite index of Canadian stocks or the Standard & Poor's 500 index of U.S. stocks. Your exact mix of funds can vary (and we'll get to the details in just a second), but the key advantage of the Couch Potato strategy is that it gives you wide diversification among hundreds of stocks and bonds at rock-bottom cost.

Why is this so important? Because low costs are crucial when it comes to investing success. Most investors pay about 2.5% of their assets each and every year to invest in actively managed mutual funds. On the other hand, you can become a Couch Potato for 0.5% a year or less. The couple of percentage points you save go directly to your bottom line and can have a tremendous effect over time.

Let's say you have a $200,000 portfolio. This year alone you would save about $4,000 by becoming a Couch Potato investor rather than an investor in actively managed mutual funds. Over a few years, assuming you reinvested all of your savings, the difference would grow and grow, because the money you would be saving would compound on itself. Assuming typical rates of return, the money you would save by becoming a Couch Potato would be more than enough to buy you a luxury car in 10 years' time even if you were never to invest another cent in your portfolio.

Whenever we lay out the math, people are naturally skeptical. It seems too good to be true. How can the mutual fund industry get away with charging us so much for so little? Doesn't all that expensive professional management accomplish something?

Sadly, no. If you doubt us, click here to see how our Classic Couch Potato portfolio has generated returns higher than 11% over the past 30 years. Or visit Scott Burns' site at Dallasnews.com and see how Burns, the inventor of the original Couch Potato approach, has fared. Compare the Potato's results to what the average actively managed mutual fund has accomplished — we think you'll be impressed. Then, if you want to better understand the reasoning behind Potato-hood, pick up Unconventional Success. It's a new book by David Swensen, the legendary investor who piloted Yale University's huge endowment fund to record-breaking performance. In his book, Swensen lays out a Couch Potato-like strategy of his own. Coincidence? We think it's merely another affirmation of the Couch Potato's unarguable logic.

The second idea is to diversify among different types of assets. By doing so, you ensure that no single blow-up can devastate your portfolio. We usually recommend that Couch Potato investors follow a classic balanced strategy, which consists of putting 60% of your money in stocks and 40% in bonds, but you may want to adjust the stock component upward if you're young and willing to take on additional risk in pursuit of larger returns. Conversely, you may want to dial down the stock portion if you're older and more conservative.

The third idea is to rebalance once a year to get back to your original asset allocation. If your stocks shoot up in value, for instance, you would sell some and put the proceeds into bonds. Doing so ensures you're constantly selling high and buying low.

That's it. If you follow those three ideas, you're going to do well. In fact, you can adapt the Couch Potato strategy to suit your individual situation and preferences. Our Classic Couch Potato Portfolio is a simple strategy that spans Canadian and U.S. markets. Our Global Couch Potato Portfolio takes things a step further and expands your portfolio to span the world. Both are just suggestions and can be tweaked to suit your purposes.

Ready to get going? We suggest you read our Couch Potato FAQs for a quick overview of the major issues. Then follow Do the Couch Potato for a step-by-step guide to implementing the strategy. Finally, visit Meet the potato family and choose the Couch Potato strategy that's right for you.