Wednesday, February 18, 2015

An Indexer Answers Investing Questions

The world of investing simplifies tremendously once you make the decision not to try to beat the markets. Complications melt away when you just try to take what the market offers at very low cost. A Wealth of Common Sense gave a long list of “underrated questions that most investors don’t bother asking themselves.” Here I answer them from my point of view of a DIY index investor. The list of questions is long, but my answers are short.

What if I’m wrong?

I don’t make bets based on hunches, so it’s hard to go too far wrong.

What are this person’s incentives for giving me advice?

I ignore forecasters. I listen to people with advice, but I don’t deviate from my current strategy of low-cost indexing, which is incompatible with most advice.

What are the all-in costs for my portfolio?

Expressed as percentages of my entire portfolio, MERs are 0.08%, my ETF trading commissions and spreads cost 0.02%, and foreign withholding taxes cost 0.10%. My U.S. ETFs don’t report their trading expense ratios, but I’m confident that this rounds to 0.00%. All-in costs are 0.20% per year, or about 5% over 25 years.

What’s my reason for making this purchase or sale?

Apart from occasional rebalancing, I buy when I have new savings to invest, and will sell when I need money. I make no trades based on market predictions.

Maybe I should give myself a few days before making this change to my portfolio?

If I was planning to change my strategy or change my asset allocation, this would make sense. But adding new money to my portfolio requires no cooling off period.

What’s my time horizon on this investment?

My time horizon is roughly my whole life. I plan to invest money until I need it to spend.

Does this strategy fit my personality or is it a case of a square peg in a round hole?

I’m quite comfortable with my strategy.

When will I sell this investment?

When I need the money to spend in less than 5 years.

Have I looked at both sides of this trade?

I just assume the investor on the other side of my trades knows more than I do about short-term prospects. I plan to hold for a very long time and am not concerned about the short term.

How will I react if the markets don’t cooperate with my thesis?

My only real thesis is that stock market tends to go up over the long term. I suppose my small cap value tilt could be called a thesis as well. If markets stop going up over the long term, the world is in trouble.

Am I saving enough money?

I’m currently saving more than 50% of my take-home pay. That’s more than enough.

Am I blaming others for this mistake instead of taking responsibility for my own actions?

I’m the only one to blame for the mistakes I made in the past playing my hunches.

How much will this change in my portfolio really affect my performance?

It’s been a long time since I made any portfolio changes other than adding new money or rebalancing.

What is my asset allocation including all of my investments?

Long-term savings are 30% Canadian stocks, 25% U.S. stocks, 20% U.S. small cap value stocks, and 25% international stocks. Short-term savings are in cash and GICs.

What’s my edge in these competitive markets?

Because I choose not to compete in the markets, I don’t need an edge. I suppose you could say I get edges from my low portfolio costs and ability to remain cool when market gets volatile.

What does the party on the other side of this trade know that I don’t?

I assume the parties on the other side of my trades know a lot more than I do. By holding assets for the long-term, I don’t need to worry much about being taken advantage of in the short term.

Am I listening to the right sources when taking financial advice?

I believe so. I tend to read books about long-term thinking rather than listen to pundits discuss short-term matters.

What’s my maximum pain threshold for losing money?

I don’t know for certain. I slept fine through the enormous stock market losses in 2008-2009. So, we’d have to face something much worse than this to make me flinch.

Am I looking at the market value of my portfolio too often?

Probably, but I’ve been improving. I have a spreadsheet that computes many things including portfolio market value and rebalancing thresholds. It now sends me an email if I need to rebalance, so I’ve been more comfortable lately not looking at the spreadsheet for days at a time. Eventually, I hope this grows to weeks at a time.

Do I understand the risks and expected returns for this asset?

I do understand the risks of my ETFs and how these risks differ between the short term and the long term. I hope for compound average expected real stock returns of 4% per year over the long term. But, I’ll be fine financially if I get substantially less.

Could I explain my investment strategy in a 30 second elevator pitch?

Index investor. Maybe for the rest of the 30 seconds I’ll practice juggling.

Do I have a reasonable time frame in mind for my portfolio?

I think the rest of my life (and my wife’s life) is reasonable.

What is the underlying liquidity in this investment vehicle?

It’s hard to get too much more liquid than the four extremely popular ETFs I own (VCN in Canada and VTI, VBR, and VXUS in the U.S.).

What are the tax complications?

Tax complications are minimal for RRSPs and TFSAs. In my non-registered accounts I hold only VCN (because of the favourable dividend treatment in Canada) and VTI (because it has the lowest dividend yield of the other three ETFs). Overall, my taxes are quite simple.

Am I being patient or just stubborn?

This question seems more relevant to active investors holding on to a poorly-performing stock. In any case, index investing requires patience (absenteeism helps, too). I’ve got the patience, but I’ve not mastered being absent. I still pay too much attention to my portfolio.

Am I diversified enough?

It’s hard to be more diversified than owning just about every stock on the planet. Some will criticize the lack of bonds in my portfolio. The diversification benefit of bonds is minimal and is swamped by the fact that bonds’ expected returns are so much lower and expected stock returns. The main benefit of bonds is controlling short-term volatility. Over 20 years or more, there’s not much difference between historical stock and bond volatility.

What are the alternatives to this investment?

Again, this question seems more suited to active investors. I have choices of different index ETFs to cover the various asset classes. I’ve made my choice and have no current plans to change it.

Will my assets cover my future liabilities?

If I work for a little while longer, the answer is yes.

Do I understand the risks involved with this strategy?

My strategy is fairly simple. The main risks are that I’ll become either fearful or overconfident and deviate from my strategy. Other than that, multiple decades of poor stock returns world-wide could cause me problems. But I’m guessing this would be a sign of much bigger problems than whether I have enough money to travel 4 times per year.

What’s my investment philosophy?


Am I trying too hard?

I used to try too hard. Now I just take what the markets give me.

Does this person offering advice on TV have the same time horizon as I do?

I rarely listen to advice from talking heads on TV, so their time horizons don’t matter much to me.

Am I anchoring to current or past price points?

This is another question mainly for active investors. No, I don’t anchor to past price points.

Are this portfolio manager’s past results too good to be true?

I don’t invest with active portfolio managers, so their past results aren’t relevant to me.

Am I allowing my confirmation bias to cloud my judgement?

I managed to break out of my confirmation biases when I made the decision to abandon active stock picking. I’m sure I suffer from confirmation biases in some parts of my life, but it isn’t relevant to indexing.

Am I the sucker here?

Seems unlikely. I suppose some new government could simply confiscate or tax away my savings. Or maybe all index funds could be forced to include “investments” in some form of public spending.

Am I chasing past performance?

In a sense. I base my return expectations on roughly the past century of real stock returns less some margin for safety. But I don’t chase recent past outperformance.

Am I imagining that past market scenarios were easier than they really were at the time?

I know that we are all prone to 20/20 hindsight. However, this isn’t relevant to buy-and-hold index investors.

Is this data important or just interesting?

I can only assume that this question is relevant to those looking for an edge over the markets. I’m not seeking such an edge other than accepting short-term volatility in exchange for higher expected returns.

Am I working with a marketing firm or an investment firm?

I own Vanguard ETFs. Vanguard is definitely an investment firm.

How did I react during past periods of market turmoil?

I slept fine and didn’t sell during the tech crash and then again during the 2008-2009 financial crisis.

Do I really understand my appetite for risk?

My biggest test was the 2008-2009 financial crisis, and I didn’t have any trouble.

Am I practicing first or second level thinking?

I strive to use second-level thinking for most things in my life, but it isn’t necessary for index investing as long as I don’t stray toward making some active bets.

Does this person have my best interests in mind?

I assume most people don’t have my best interests in mind.

Can I stick with my process when things don’t go as planned in the future?

My plan allows for significant volatility of year-to-year returns. So, it would be difficult for things to work out differently from my plan. However, I believe I can stick to my process.

Am I anchoring to a bad investment or staying disciplined to a good process?

This is another question more relevant to active investors. Anchoring doesn’t seem to be a problem for index investing.

One thing that should have been clear reading through all these questions and answers is that index investing is a lot simpler than trying to beat the market in one way or another.


  1. MJ, what's your view of the various "objective" valuation measures like Schiller's PE, the sorts of measures cited by value investors like John Hussman, Jeremy Grantham, etc? I'm not suggesting they be used to time the market in the short term, but I do find them hard to resist in terms of making some broad decisions about how much of my total portfolio should presently be in equities. Mr. Hussman, for example, projects 10 year nominal returns for the S&P 500 of less than 2% and offers some pretty persuasive arguments supporting the notion that, historically speaking, we're very near (if not at) another market top. I'm an indexer but can't seem to convince myself to push all my chips in until a significant correction occurs. So like many I suspect, I'm one foot in, one foot out, most likely to my own detriment.

    1. @J: Paying attention to such measures is a form of market timing, but with just a fraction of your portfolio. I've stopped paying attention to any such measures. They all sound intelligent, and maybe some of them actually have some value, but I can't tell which. I go on the theory that any moves I make have the expectation of costing me money. Your mileage may vary.

  2. Love your answers! A couple of slitting hairs type questions. I am curious as to how you came to your allocation between Canadian, US and International equity. Why not just 1/3 each? As you have chosen a small value tilt with US equities, why not do the same with international with eg. DLS? It's the one Rick Ferri recommends, so although is is a bit expensive the high factor loadings, I believe, make it worthwhile.

    Could you expand on the subject of there being not much difference in the historical volatililty of bonds and stocks over 20 years or more, or direct me to a resource? I couldn't find much on the subject via google. Thanks!

    1. @Grant: The following article explains my reasoning for my asset allocation:

      I never seriously investigated a small value tilt with international stocks. I find the MER plus withholding taxes on VXUS painful enough. Perhaps DLS isn't worse but I haven't checked.

      Here is an article I wrote on the subject of historical stock and bond long-term volatility:

      Long-term volatilities were also discussed in a book I reviewed:

  3. Too funny :)
    "Index investor. Maybe for the rest of the 30 seconds I’ll practice juggling."

    Nice work Michael, I enjoyed this one.

    I think my answers wouldn't be as straightforward. Maybe I need to take the same test. We can compare notes!


    1. @Mark: It's kind of a long test, but if you make it through, I'll be interested to have a read of your answers.

  4. Wondering if you plan to change your asset allocation? I mean at some point as you are approaching retirement or when you retire? Or is that not necessary because you have enough pension such that it doesn't matter if your portfolio drops by 50% and stays that way for 10 years you can still cover your fixed expenses?

    1. @Anonymous: My asset allocation is for money I don't need for 5 years or more. I intend for this allocation to stay the same in retirement. But what will change is that I'll need 5 years worth of spending within 5 years. So, that money will be in safe investments like GICs, HISAs, or cash. If you look at everything together, then the asset allocation will look like it has changed, but I view short- and medium-term savings as separate from long-term investments.

    2. Do you really need that much risk?
      Does your required rate of portfolio return in retirement need that much equity risk? A Japanese type deflationary spiral of 1990 which saw the Nikkei plunge from 40000 to 10000 and just now starting to recover is possible here given the debt madness! Like you I too survived our own 2008 downturn without selling my stocks but now I'm much nearer to retirement and I know my wife could not handle a prolonged deflationary cycle and so I'm hampered by her different risk tolerance. How do you convince your wife :)?

    3. @Anonymous: I don't think it's really that much risk. For $5000/month fro 5 years, that's $300,000 in GICs or HISAs or cash. That's quite a buffer against a downturn. As for the downturn in Japan, I have my investments spread across the whole world.

      It's true that my wife is risk-averse. If I die, she's likely to sell everything and put it all in GICs. But with me around she seems comfortable enough with our current strategy.