Tuesday, November 15, 2011

Getting Started with Index Investing

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:

RRSP:

$700 Canadian stocks
$600 U.S. stocks
$400 International stocks
$300 Canadian bonds

TFSA:

$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.

Tax Efficiency

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.

Temptation

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.

Enthusiasm

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.

12 comments:

  1. if you're starting out with a small portfolio, wouldn't it make more sense to take advantage of the commission-free etfs offered by various brokers (eg. itrade)? I know the MERs are a little higher than the preferred etfs (like XIC), but this will allow Amy to buy all 4 assets without paying any commissions and get that satisfaction of hitting your mix immediately. Once you build up your savings, you can switch to the cheaper etfs to save on MERs.

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  2. @Chris B: Your approach has advantages and disadvantages compared to the one I described. Some disadvantages are a restricted set of ETF choices leading to higher MERs and a need to sell them and buy something else later. The main advantages are no commissions allowing Amy to match her asset allocation right away. But this advantage is only important if she has an emotional need to match her asset allocation right away. If she does, then your plan is a winner. But matching her allocation right from the beginning really isn't important to her long-term capital growth.

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  3. No one should ever 'get excited' about index investing., In fact, 'getting excited' is exactly the wrong mindset for investors.

    Think dull, boring, plodding, gradual and successful. But never exciting.

    It may be difficult to begin without a sense of enthusiasm, but that should be geared to the idea that the approach being adopted has a good chance of providing a better return than almost anything else that she is (currently) capable of doing for herself.

    Thanks for sharing.

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  4. @Mark: There's a fine line here. Getting started requires some enthusiasm, but too much can lead to problems, as you say. Rather than "dull, boring, plodding, gradual and successful" I would paint a more positive picture by saying that it is "undemanding, gradual, and successful".

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  5. Speaking as a 34 year old who started investing in September 2009, I think it's best to take the "ETF plunge" from the start and to build up various asset classes... while it might not be optimal from a numbers point of view, it gets you used to the market, to the broker's web interface, to bid-ask spreads, etc. Having an unbalanced portfolio at first isn't as much of an issue, and as the account grows you can add diversity (ie, at a certain point, add REITs, whereas for a small account they're no needed).

    It also makes you learn about your own reactions, before the money involved is too massive for mistakes to be as severe.

    For example, I got to learn that I won't sell, or even be tempted to sell, when the market falls, but I'm also unable to talk myself into rebalancing. I'd rather know how I react when 5K$ are involved than when I reach 50K$ and ETFs become advantageous.

    -Paul G.

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  6. @Paul: It sounds like you've used an approach similar to our fictitious Amy. I'm glad to hear that you didn't panic through the downturn.

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  7. Sound advice Michael.

    I have to agree (and like what) Mark W. said...investing is not meant to be exciting.

    In fact, the more boring my investments can be, the better I will do in the long-run.

    As for getting started with ETFs, I think anytime is a good time, so long as you're not going crazy with purchases and getting hit with lots of transaction fees. The sooner I can get my money working for me, the better.

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  8. I scoff at you indexers! To you guys, "boring is the new exciting!"

    I'm just kidding. Indexing is the only method I feel comfortable recommending to others, even if I use individual securities. It's a solid strategy.

    Back to the topic: your post assumes $10 stock trades. Amy might have trouble qualifying for these low commissions unless she shops around. Questrade would be a good option for her, though some people have had horrific experiences with them.

    You've got some practical advice here, hopefully it helps some new investors.

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  9. @Mark: Investing can be very exciting, but you're right that successful investing tends to be pretty boring.

    @Gene: That's a good point about higher commissions for smaller accounts. For someone in this situation, I think it makes even more sense to not worry about the perfect asset allocation early on and just make larger trades.

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  10. It really is too bad that the index mutual funds options are so poor in Canada. To those who are starting out I say look at TD's eSeries index Mutual Funds. They're a good way to learn about purchasing funds and asset allocation.

    I also use my eSeries account for mini rebalancing by adding where necessary and for small tactical (market timing) purchases as their is no cost to exchange funds that have been held for 90 days. Otherwise, I agree it is wise to have a minimum amount before making a trade (mine is also $3,000).

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  11. @JTN: TD eSeries funds are a little expensive compared to the best ETFs, but are a fine way to build a portfolio.

    Be careful about your tactical moves. Always remember that you're trading against institutional investors who are convinced that the opposite tactical move is correct.

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  12. There are two things that determine one's total take by the time they retire:

    1) What year they start investing. I think you could start at 25, invest for 10 years, stop, and still have more at the end than someone who starts at 35 and invests for 30 years. Just an example, but the point is time is your friend.

    2) Asset allocation determines 95% of your returns, whatever your investment vehicle.

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