Thursday, June 6, 2013

Couch Potato Investors are Rare

Passive investing using low-cost index ETFs and mutual funds is rising in popularity. The number of investors who are excited by the idea of couch potato investing is growing every day. However, in a recent conversation I had with Canadian Capitalist, he observed that enthusiastic couch potatoes usually don’t really invest passively. Sadly, I have to agree.

Let me start by admitting my own transgressions. It took me many years as a stock-picker before I finally decided that I was better off investing passively. Even then I took my sweet time selling off individual stocks and buying low-cost broadly-diversified ETFs. I still hold one individual stock (Berkshire Hathaway) for less than 10% of my portfolio. I don’t intend to ever buy more Berkshire, but this is still a deviation from index investing.

So, I’m not a pure passive investor. But, even if we adopt fairly lax standards for what constitutes passive index investing, few self-described couch potatoes meet the test. Following are 3 categories of not-really-passive investors that I’ve seen.

Stock Picker on the Side

These investors have most of their savings invested passively, but keep 10% or 20% in a side account to scratch their stock-picking itch. The trouble is that in this smaller account their annual stock turnover might be 100%, 300%, or more. This frequent trading usually leads to losses, and replenishing side accounts takes savings away from the passive part of their portfolios.

Dividend Investor on the Side

The idea of collecting fat dividend cheques is irresistible to some investors. Fortunately, most dividend investors hold their stocks for long periods. They usually suffer from too much stock concentration, but adding some dividend stocks on the side of a passive portfolio is likely to be the least damaging of the three types of not-really couch potato investors described here.

ETF Market Timer

I’m always baffled when an investor listens to my short pitch for passive investing and responds with something like “I love couch potato investing. I’ve been doing it for a couple of years. Do you think the stock market is overvalued right now? I sold out of XIU and VTI a few months ago, but I’m wondering whether now is the time to get back in.” These people just won’t believe me when I say I have no idea where the market is headed in the short term. They are very far from being couch potatoes and their long-term returns are very likely to fall a long way short of market returns.

On average, any deviation from pure passive investing is likely to lose money. There will always be those who manage to beat the market, but more will lose to the market.

16 comments:

  1. Meh, Berkshire is basically an index fund: you get exposure to a wide array of US businesses (including many you could not otherwise own because they are privately held by BRK) with a good degree of internal diversification. The effective MER is low, it's tax-efficient, and more liquid than many ETFs you could pick.

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    1. @Potato: It's certainly true that some deviations from pure passive investing are more significant than others. But I still think I can`t really wear the couch potato baseball cap until I sell Berkshire.

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    2. I don't see the huge distinction between S&P getting to define an index but not Warren Buffet. For passive investing it meets most of the important criteria: well-diversified, low turnover, low overhead costs, tax efficient, liquid. It doesn't hold as many names as the S&P500, but more than the Dow or TSX60, which are apparently fine choices for a passive investor. Indeed, with 50-some large companies you can't get exposure to anywhere else because they're privately held subsidiaries, you almost have to have a decent BRK weighting just to get that back ;)

      [I know I'm getting the magnitudes all wrong -- those would be captured in BRK's overall market cap]

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    3. @Potato: I think there are two differences. The first is that the S&P uses more objective criteria for making up their indexes than Buffett uses. The second is that Berkshire has more concentrated risk. If Buffett or his successor decides to make a big bet with a large fraction of Berkshire's assets that goes badly, then the entire "fund" will get dragged down quickly. This is much less likely with S&P indexes.

      All that said, though, I do think of Berkshire as a type of fund.

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  2. I have 2 Canadian Banks I hold currently, just because I don't have the heart to sell them (so I guess I am a closet Dividend Dude)however that is only in 1 savings vehicle in all others it's easier just to rebalance every year (with new money going in doing the rebalancing).

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    1. @Big Cajun Man: Your situation is typical of investors who embrace couch potato investing. They tend to deviate from it in different ways (a small way in your case, but big ways for some others).

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  3. I used to be a "buy and hold" index investor. I still am an index investor, just not a "buy and hold" one.

    Short term, the market is random and unpredictable. But, valuation at the time of purchase DOES affect long term future returns. No one can really argue against this. If you buy when prices are high, your returns are going to be lower .

    Warren Buffett buy stocks when the price is right. It makes sense to buy an index when it's valuation is lower and to cut back a bit when its valuation is high and long term returns are likely to be below average.

    Robert Shiller's CAPE Ratio allows the investor to predict likely long term returns at the time of purchase of an index, and therefore assess how much of an allocation should be risked in that index.

    Warren Buffett does not buy stocks that are over valued. Why should an index investor be any different?

    "Most individuals do not have a sufficiently long time frame to recover from large drawdowns from risky asset classes."

    You may change your view on this after you read these two papers.

    Global Value: Building Trading Models with the 10 Year CAPE
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2129474

    A Quantitative Approach to Tactical Asset Allocation
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=962461

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    1. @Jim: Based on your description of your investing approach, I would not place you among investors who claim to follow the couch potato philosophy. You deviate from it by choice and you know why.

      I've read the two papers you pointed to. The methods described would have worked well on past returns. Who knows about the future. I see no reason why these inefficiencies should persist, particularly as they are popularized and trading undermines them. Maybe I'd be better off using them, but I'm concerned that I'd be worse off and pay for extra trading costs as well.

      The only inefficiency that I've bet my portfolio on is unreasonably high risk aversion (which explains why stocks perform so much better than everything else). I haven't seen anything else that seems likely to persist.

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    2. Jim, have you looked at the CAPE ETF by any chance? It's something I'm looking into.

      I'm definitely on the value investing, not the couch potato investing camp. I'm hesitant to follow a formulaic value approach like that employed by CAPE, but it sounds sensible to me.

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    3. Although that sounds interesting, I would be cautious about over-reliance on a single indicator and the need to find something better if you decide you don't want to invest in stocks (easier done 20 years ago than today).

      An interesting study from Vanguard last year showed that the 1-year trailing P/E, the 10-year CAPE, and everything in between had approximately similar predictive value. But at any given time they could be predicting different things.

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  4. I definitely fall into the "Dividend Investor on the Side".

    My wife's RRSP is almost entirely indexed, the usual suspects XIU, VTI, VXUS.

    My portfolio, not so much. VTI and XIU in the RRSP but a bunch of U.S. stocks in there as well. I own about 28 CDN stocks in TFSAs and non-registered.

    I have a one-two investing punch. Seems to be working since it has allowed me to stick to a plan. I suspect as I get older, I'll own more VTI, XIU vs. buying individual stocks.

    All that to say, agreed, pure indexers are rare.

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    1. @Mark: Two important elements are low turnover and sticking to a plan. It sounds like you're doing both.

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  5. My only deviation is to periodically change weightings among asset classes, with the aim of buying more of whatever is unpopular. But then there is no universally agreed-on asset allocation for indexers, so it's hard to say how far I might be from "pure" indexing at any time.

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    1. @Value Indexer: If you're just sticking to fixed asset allocation percentages, then this is close to index investing. However, if you make tactical shifts in percentages based on hunches, then you're getting further away from pure indexing.

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  6. I've been index investing for years. I don't own any single stocks. Historically i used RBC's index funds and then yearly sold them and put them into xbb/xiu/spy/vti/efa.

    More recently my cash flow has become a bit more erratic and so i'm considering just purchasing a few of xbb/xiu/spy/vti/efa each quarter based on which asset allocations are "off" and need topping up.

    Does this make me an "ETF Market Timer"? Any suggestions on how frequently i should be investing?

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    1. @Erin: I would say that market timers are those who trade not because they have money to invest or need money to live on but because they have some opinion about the market's direction. So, a market timer would sell investments and hold cash for some period of time believing that the market is headed down. You sound like you're just investing when you have the money available. If this is right and you are sticking to an asset allocation, then I'd say you are an index investor and not a market timer.

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