Tuesday, May 29, 2012

Gordon Pape on Couch Potato Investing

Gordon Pape devoted a section in his book Retirement’s Harsh New Realities to couch potato investing. I was quite interested to read it because it’s important to pay attention to criticisms of your investing strategies. If I only read books by proponents of my way of investing, I won’t learn much new. Unfortunately, Pape’s criticisms of couch potato investing were disappointing.

Pape “agrees that the couch potato concept is easy to understand,” that “ETFs and index mutual funds are cheaper,” and that “the savings go straight to the bottom line in the form of higher returns.” However, Pape thinks that passive investing fails on “how safe the investment is and how much you will end up earning on your money” because of time horizon and human nature.

Pape claims that passive investing requires a long-term view and that retirees “need to see profits sooner ... especially for those who depend on their investments to generate income.” ETFs and index mutual funds can be used to match the risk level of any combination of active mutual funds. Passive investing is not synonymous with heavy stock ownership. Investors requiring safety can choose a portfolio allocation that is heavy in bonds, GICs, or cash. Passive investors don’t get eye-popping dividends, but ETFs and mutual funds with high distributions do so by directly or indirectly returning investors’ capital; high incomes are illusory.

On the human nature front, Pape observes that markets can be volatile, and that many passive investors could not have kept their nerve through the 2008 stock market crash if they were invested in his example ETF portfolio. However, investors in active mutual funds sold out at low prices during the crash as well. This isn’t an active versus passive argument; it is an argument about choosing an appropriate risk level.

Pape closes with “while it’s true that you might do worse by actively managing your money, at least you, and not the markets, are in control of your financial fate.” However, few active investors actually manage their own money; they pay someone else to do this. These investors are at the mercy of markets and professional money managers. Any feeling of added control is mostly an illusion. The main things that investors can truly control are the level of risk they take on and the fees they pay. Over the long term, passive investors paying low fees are almost certain to get higher returns than active investors who take on the same level of risk.

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