How I Learned to Stop Worrying and Love the Market

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:

  1. 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.
  2. 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.
  3. 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.]


  1. Holy cow! What was in that Chianti….and where can I get some!

  2. And to think I knew him when he hadn’t even read The Wealthy Barber yet. It brings a tear to my eye to know that with the right encouragement you can take a financial ludite and turn him into the next Mr. Buffet. I’m so proud.

  3. Only not Buffett – because he doesn’t index! 🙂 To be fair though, as I’ve mentioned to you in the past – people who can wake up one morning and buy a controlling interest in Dow Corning don’t really count as examples of either camp – they are sort of a special class unto themselves. 🙂

  4. Modern Portfolio Theory :The Precursor of Modern Mutual Funds Selection Theory

    Markowitz Modern Portfolio Theory (MPT) published in 1952 and the Nobel Prize in Economic Sciences awarded to him in 1990 was an important step in the development of portfolio management. It used science to discourage the then prevailing risky buy – hold strategy of a single stock in a portfolio. The introduction of diversification and reduced risk in portfolio management proved efficacious for the next half century.

    However since 1952, the investment markets have seen drastic changes, not the least of which, is the exponential growth of mutual funds from about 100 to currently almost 13,000. Funds have eclipsed stocks in most portfolios. Mutual funds now offer more than 200 million investors the allure of diversification with less risk and greater average investor returns.

    This has not altogether happened.

    Investors were the recipients of diversification with less risk but not improvement in net return levels.


    It is generally agreed mutual fund portfolios do create diversification and in so doing reduce risk but what has been the net effect on improving returns. Investor returns since Markowitz work in 1952 and since the emergence of mutual funds in the mid-1920’s have remained the same producing a sub zero sum game.

    What would explain the difference between the S&P 500 Stock Index gross return of 11-12% over the last quarter of a century and average investor gross returns of 7.5% annually? Going from gross to net returns, taxes explain 3.5%, inflation 3.0 -3.5%, costs/expenses another 2.0% for a total difference of 8.5 – 9.0% annually. If an investor were fortunate enough to win the 5% chance of selecting funds whose performance equaled the S&P 500 annual return of 11 – 12%, it would be reduced by 8.5 – 9.0% leaving a net return of 2.5 – 3.0%. The average selection skilled investor would, of course, do worse with a net return of minus 1.0 -1.5% annually.

    Since it is practically impossible to effect significant reductions in taxes, inflation and cost/expenses over time, the use of the Modern Theory of Mutual Fund Selection represents an unpredicted viable opportunity to significantly improve the net returns of the fund investor.

  5. The Anxiety of Randomness

    Randomness is associated with data overload and noise.

    Data overload exists when the investor is confronted by sheer volume of data. Much of these data have little or nothing to do with providing clues to expected outcomes. An example would be to follow the increase in the loads and expense ratios of mutual funds to escape the inevitability of a zero sum game outcome. The financial press supported by industry pundits regularly refer to these statistics even though they do not explain fund persistency. The same would be true of trying to find “hot hands” fund managers through years of tenure to explain outcomes. It does not work.

    Investors following these and other data do so in the belief that some additional market insights can be gleaned even though 97% of all outcomes can be explained by past performance – the third rail of the industry. Then why is so much energy exerted in the quest to find the superfluous 3%?

    Data noise and randomness produce anxiety by exerting undue influence on investor decisions by over-emphasizing the importance short time fluctuations.
    Looking at net asset values too frequently leads to the confusion between “meaningless” random and “more convincing” smoothed data .This leads to producing too many wrong “buy-sell” decisions that are emotionally driven.

    One way to lessen the effect of anxiety requires the belief
    that the value of data increases, to a point, with the passage of time. Let’s take mutual fund total return data, for example. Weekly is more revealing than daily data. Monthly is more revealing than weekly data. Quarterly is more revealing than monthly data. Semi-annual (hardly ever published for some strange reason) is more revealing than quarterly data. Yearly might be more revealing than semi-annually data. Three years might be more revealing than yearly data. Five years might be more revealing than three year data. Ten years or more would be less revealing than shorter time interval data because it probably describes more than one market cycle.

    Depending on the part of the market continuum, no “one” time frame is revealing but a “combination” of several would be.

    In an attempt to lessen anxiety too many investors also use the “ostrich” approach by not monitoring performance for many years. This leads to delayed but severe anxiety if the performance is strongly negative. This is usually associated with investment behavior without the benefit of concrete facts, goals and a way to measure progress against goals on a periodic basis.

    Another anxiety ridden behavior is to invest based on the publicized opinions of well-known advisers, managers, writers or others without the benefit of supporting facts and considering personal issues of suitability, risk ,cash flow… can be injurious to financial health. The analogy to this would be in the field of health care : taking someone else’s Rx with the expectation of a speedy, complete recovery.

    Arthur Regen

  6. After 14 years of research, we know why both mutual fund investors and the professionals are not playing on a level field and consistently under perform.
    This is above and beyond the recent Wall Street bail-out debacle.

    Of the 7 trillion USD invested in mutual funds, 4 trillion USD averages a meager 4% annually while the S&P 500 averages 10+% – also no great shakes considering the ravages of inflation and taxes. The result is that retirement will be a distant dream or night-mare for hundreds of millions of investors.


    Pension and 401K plans consistently under perform the S&P 500 placing blue and white collar retirement in jeopardy. State government employee retirement plans are dangerously underfunded.


    Industry gurus proclaim costs and expenses are to blame. If all costs and expenses were zero the S&P 500 would still not be beaten consistently but by chance.

    Why is the academic so silent in these matters.

    There hasn’t been a major beneficial breakthrough in investment management since Markowitz 1952 work until now.

    Arthur Regen, MBA,
    Managing Director
    Chester M. Regen, PhD
    Technical Adviser
    Neil I. Miller, PhD
    Director of Research