Maybe it’s the Chianti talking, but I’ve got something to say about investing: get your plan sorted out because I have exactly zero interest in paying for your retirement. Every day you decide not to bother, or say you’ll think about that in a few years, or complain that other things are more pressing, is a day you’re leeching off my taxes, my CPP, my hard work.
And the worst part is: it’s not hard to be smarter than almost everyone. You can sit down in an hour and get yourself set up to do better than top-dollar money managers.
All you have to do, and it’s a tough pill, is get used to the idea that it’s not very exciting you don’t get to brag about it.
Note: everyone with an interest in finance is sure, is damn hell ass convinced, that they have it sorted and the ones on different bandwagons are doomed to destitution. I’m a little more Canadian about the whole thing, because any investment plan is better than none, but clearly I also have my own opinions, so add salt to taste. You, in your special and unique snowflake of a situation, should probably retain 10 financial planners to manage your affairs, I guess. Consider this advice suitably disclaimed. In fact this isn’t even advice, it’s drunken rambling and you should stop reading.
Okay. So. You’ve got your brain clear on the whole budgeting scam, and you’re ready to start tackling the bigger questions. You know you should save. You have heard about Freedom 55 and that sounds nice enough. You don’t know anything about stocks and bonds and mutual funds and derivatives and secondary markets and e-trade and selling short and day trading and you are sort of worried that you’re going to have to learn about some of that. Or worse, much worse, you know a little about some of those things, and you’re buying stocks based on P/E ratios and dividend yields, without actually knowing how to read a balance sheet. If you’re Canadian you’ve heard of RRSPs and are certain that they are something responsible people have, or maybe you have one but still don’t quite get what makes it different or what to do with its contents (they have contents?) Back that truck up. We’ll get there. The whole point of the anti-budgeting rant was that you shouldn’t have to work that hard just to manage your money. The same goes for investing, and doubly so, because working too hard is going to cost you money.
Investing for retirement is good. It gives you a sense of security and accomplishment. It makes it easier to get big loans because it increases your net worth in the interim. It stops you from being a leech. Governments tend to like it too: money you’re investing is money they aren’t going to have to come up with in 30 years when you stop working but keep eating. They like it so much that they create incentives the only way they’ve been clever enough to come up with in lo these 2000 years: tax breaks. An RRSP is just an account managed according to certain rules designed to ensure it is a retirement account, not a saving-for-jamaica account. You play by the rules (or more likely your investment company does) and the government agrees to let you write off the cost of your contributions to certain reasonably interesting maximums. That’s it. They do this partly because they want to encourage you, and mostly because they intend to tax it on the way out instead. There are reasons you might prefer to stay outside an RRSP, but you might as well put it into an RRSP for now since that tends to work for most people. Our friends to the south have similar setups, 401(k)s and the like. So, it’s just an investment account with a certain tax status. The question of what to invest in is still the big question.
There are several popular answers to that question, but most people come back to one of three things:
- A “no hassle RRSP” account like this one from ING. These invest in money markets: GICs, T-bills and other guaranteed paper. They are low risk, and they are low return. Very low return. That’s how the market works, and it’s important to get it right in your head: risk< ->return. Anyone tells you they have a way to break that formula is breaking the law or lying or both: in an efficient first world market, risk and return are directly and strongly correlated. Not perfectly correlated, because it’s possible to take stupid risks and not be rewarded appropriately, but if you think you have found rewards beyond their risk, I submit you aren’t assessing the risk properly.
- Mutual funds. The idea here is quoted extremely frequently: “I figure I’ll pay someone else to manage my money because they do it for a living and they ought to be better at it than me.” Wow. Amazing how wrong that ends up being, because it sounds really good.
- Stocks & Bonds. Full on, brass tacks, balls swinging long and low, playing with the big boys, taking off the kid gloves capital markets extravaganza. Real shame about the sucking.
So return and risk being two sides of the same coin, that’s the first HUGE thing to take away from this article, and hot on its heels comes the second thing:
The market is smarter than you AND that other guy
It is fantastically, exceedingly, profoundly and in all other ways utterly unlikely that any single person or small group of people can beat the market. Not just in theoretical magic land, but actual historical fact. Markets are smart. Particularly high volume, high information, high transparency, low barrier to entry, first world capital markets like, say, all the ones you might be investing in. Crazy smart.
In case you hadn’t noticed, options 2 and 3 above are really the same thing, the only question is which monkey is doing the buying: in option 2 it’s a fund manager, in option 3 you are your own fund manager. The point is the same, and hold on to your bippies, because I’m gonna drop another bomb here:
Over the long term, the proportion of mutual fund managers that can beat the market as a whole — that is, the proportion whose returns are better than the brain-dead returns you would get from, say, buying every stock in the S&P 500 in the same proportions that S&P does — is vanishingly small. And the ones who did it last year are no better than chance to do it again this year. I’m serious as a heart attack here: it’s a steaming pile of monkeys throwing darts. Morningstar’s interface has changed lately so I don’t know how to do it now but for the longest time it was pretty straightforward to build a list of all mutual funds with 10 year histories that trade in S&P 500 stocks (or TSX 300 stocks, or whatever) and plot their returns against the growth/shrinkage of the S&P 500 itself. Less than a quarter could match the index, and these guys are getting paid millions of dollars, and have research departments and analysts working overtime. They even charge you commissions to buy, sell and own their fund units because of the fantastic service they provide. Less than a quarter. And not the same group over different ranges either – they’re almost all dogs. It’s heartbreaking and mind blowing at the same time! They look like they’re trying so hard!
What gives, you ask? The answer is that the market is smarter than any one person. Think about it: every stock with a ticker on the NYSE has a stock price that represents the collective thinking and action and biases and research of millions of traders – it is a very informed number. When a mutual fund manager decides to buy one stock or sell another, he is betting against everyone else put together. He might be right short term, the market does some extremely stupid things short term, but over the long term he basically never is, the market wins almost every race. And when the market doesn’t win, you can’t tell ahead of time who the winners will be. Those “10 hot funds for 2006” issues of Financial Post are a joke – go find the ones from 2001 and see how they turned out. See where they’re at today. I don’t ascribe to malice what can be ascribed instead to incompetence, but the fact that this whole industry hasn’t caved in on itself is a testament to the human belief that this time it will be different. It would be touching if people weren’t losing so much money.
If you love the market so much, why don’t you marry it?
Trade stocks. Buy mutual funds with so-called “proven track records.” You probably won’t even lose money in the long term if you pick well, and there will definitely be years when you can brag about how you made more than I did. But what you are doing is taking more risk – the risk of buying a few individual stocks, attaching your fortunes to a few individual fund managers – without getting more reward. You’re even paying commissions for the privilege. You’re in what is affectionately known as the “crappy” part of the graph. The other option is to just buy the whole market. This is tough: you’re not going to get bragging rights, you aren’t going to have any “hot tips” from your broker. You are going to buy the whole damned boring market because, truth is, companies tend to find efficiencies, manufacturing processes tend to improve, companies tend to prosper, and stocks tend to rise. And you don’t need the ego trip that comes from picking the next hot thing – you just put your faith in humanity to get it right by and large. Really a very hippie approach to investing but unlike most hippie crap, it’s got a track record of actual successes. I’m talking about buying…
Index funds. These are mutual funds, but not mutual funds. They are funds in the sense that they are a pooled co-operative investment in which units are purchased in whole or part, managed by a company which reinvests proceeds in the fund units or in the form of dividends, less some administrative costs. They are not funds in the sense that there is no magic money manager who’s supposed to be younger and bolder and more dynamic than the other guys. Instead there is a guy who still has to be relatively smart, but whose job is to keep the fund performance as close as possible to the market as a whole, and not get any crazy ideas into his head. He charges a HELL of a lot less in administration (about 0.5%/yr versus 2-3% for active mutual funds), he tends to match the market to within a percentage point. He tends therefore to beat almost all the other funds on the street, and kids: this boy’s returns ARE going to keep tracking the index next year and the year after. For better or for worse.
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That’s it. You want practical details, okay prepare for bullet time:
- Call TD Waterhouse and tell them you want an efunds account. There are lots of Canadian brokerages and most of them will do index fund trading, but waterhouse has the lowest fees and all right now, and a good web interface.
- Set up those automatic deposits. How much to save is a tough question but I promise 10% of your income isn’t as big as it sounds. Once it is disappearing regularly, you’ll barely notice.
- Buy index funds. Don’t brag, but quietly pat yourself on the back. You can buy most of the TD index funds with as little as $500 at a time, and there are no commissions for buying or selling (except a penalty for selling within 90 days of buying, but you’re not screwing around like that, you buy and then buy more, you don’t need to sell).
Last question is what indexes to buy. Canadian? US? EAFE (Europe, Australia, Far East)? There are even index funds that track the whole canadian bond market, or US bond market. Ready for another boring but successful answer?
The Armchair Portfolio
I sure as heck didn’t invent this. But it works pretty well:
25% Canadian Equity (Stock) Index (TSX300)
25% Canadian Bond Index (Scotia Capital Markets index)
25% American Equity Index (S&P 500)
25% EAFE (Morgan Stanley Capital index)
Once a year or so, you check where things are at. If one of those buckets ever gets more than 5% out of whack, you sell an overweight one to pick up more of the underweight one and get back to even. Or even better, you deposit some more money into the RRSP and use that to buy up the underweight segments. The rebalancing is key, since it forces you to sell high and buy low, but be calm about it – once every year or two is fine – too much balancing could get you into those 90 day penalties and doesn’t add any value.
An armchair portfolio of index funds. It’s nothing new, index fund companies are some of the largest in the world. But it might be new to you, and it’s easy enough to understand, I hope. You aren’t making daily trades, you’re buying whole markets. It’s boring. And it works. Now that didn’t hurt too much, did it?
[Ancilliary disclaimer: I’m sorry I called you dumb. If you are comfortable with your plan of buying blue chip dividend paying stocks, or high yield income trusts, or a diversified portfolio of sector funds, or whatever other sensible-sounding thing, then I’m glad. The most important part is that at least you’re investing instead of pinning your hopes on the lottery. You and me, we’re buds. But I wrote this for those of our compatriots who are ducking the whole thing. They need to know that it’s not all that tough, because lord help them if they don’t. Lord help us all if they don’t.]