A common problem for young investors who get excited about index investing is that they try to over-think their portfolios in their early saving years. Your asset mix is much more important when your portfolio is much larger than your new contributions than it is when you're just starting out. I'll go through a fictitious example to illustrate a pattern I've seen with novice index investors.
Amy is a responsible woman in her mid-twenties with a good job who wants to start building savings for her future. She has read about index investing and is excited to learn that she doesn't have to be an expert on stock picking to be a successful investor. After some study she has settled on the following asset mix:
35% Canadian stocks
30% U.S. stocks
20% International stocks
15% Canadian bonds
She has picked the 4 ETFs she plans to use for these asset classes, and she has RRSP and TFSA accounts opened with a discount brokerage. Right now she has $2000 in her RRSP and $2500 in her TFSA. This leads her to the following allocations:
$700 Canadian stocks
$600 U.S. stocks
$400 International stocks
$300 Canadian bonds
$875 Canadian stocks
$750 U.S. stocks
$500 International stocks
$375 Canadian bonds
The problem here is that it will cost her $80 in commissions plus a smaller amount in spreads to make these 8 purchases. This represents about 2% of her portfolio right now. It just doesn't make sense to spend this much right now.
However, Amy has set up some automatic withdrawals from her pay to add $400 per month to her TFSA and $600 per month to her RRSP. In just 5 months her savings will more than double. But what should she do right now?
One approach is to set a minimum dollar amount, such as $2000, and wait until each account has this minimum in cash before making a purchase of whichever asset class is furthest below its allocation (in dollars). So right now her accounts hold a total of $4500 in cash. The asset class that is furthest below its target allocation is Canadian stocks which are supposed to have $1575. But Amy just buys the Canadian stock ETF with her entire TFSA ($2500). After this purchase, the U.S. stock ETF is furthest below its intended allocation. So, she buys the U.S. stock ETF with the entire contents of her RRSP. In the coming months, her accounts will build cash until she is able to make purchases of ETFs in her other asset classes.
There are a few potential issues with this approach. One related to tax efficiency, and the others are mostly psychological.
U.S. stocks are better held in an RRSP than a TFSA because there won't be a 15% withholding tax on U.S. dividends for U.S. assets held in an RRSP. So Amy should arrange things so that she tends to buy the U.S. stock ETF (and possibly the international stock ETF) in her RRSP.
With cash just sitting around for a few months in her RRSP and TFSA, Amy may be tempted to take a vacation rather than buy ETFs once the cash builds up to $2000. Each investor has to assess his or her personality when making a plan. If cash in a retirement account feels like cash burning a hole in your pocket, then maybe you have to pay a little extra in commissions by making smaller trades.
It's hard to start anything new without a good dose of enthusiasm. Unfortunately, Amy has just done the work to figure out her preferred asset allocation, and she now realizes that she won't get anywhere close to that allocation for a couple of years when she has saved more money. This is somewhat deflating. If Amy follows the plan described above she will be fine, but it doesn't feel very satisfying right now. Paying the extra commissions to get to the right allocation (and maintaining it thereafter) is an expensive way to feel satisfied.
Some observers will say that Amy is better off with TD e-series mutual funds because her account is small and will stay fairly small for a few years. However, she may not want the hassle of switching approaches in 5 years. If she follows the plan laid out above, she will not pay excessive fees; an ETF approach will work nicely.
My personal rule is that I don't make an ETF purchase until I have $3000 in cash, and I often wait until I have $5000 or more. This can lead to fairly large amounts of cash sitting in the 9 accounts my wife and I have. However, this cash (in the non-RRSP accounts) serves as part of my emergency cash reserve.
It’s much more important for Amy to focus on saving regularly than it is for her to have the perfect asset allocation right now.