Couch Potato FAQ

What is the Couch Potato strategy?

The Couch Potato strategy is a technique for building a diversified, low-maintenance portfolio designed to deliver the same returns as the overall stock and bond markets, minus very small fees. The strategy can reduce a typical investor’s costs by 90% or more, while at the same time beating the vast majority of mutual funds and professionally managed accounts.

The strategy — also called index investing, or passive investing — has been around for decades, though it has become far more popular in recent years, as new products and online discount brokerages have made it easier to implement. Anyone can now build and maintain their own investment portfolio using Index mutual funds and exchange-traded funds (ETFs).

What’s an index mutual fund?

First, it’s important to understand what an index is: it’s a group of stocks or bonds used to measure the performance of a particular market. For instance, the S&P/TSX Composite includes about 220 companies traded on the Toronto Stock Exchange, and it’s considered a barometer of the entire Canadian stock market. When you hear a business reporter say “Canadian stocks were up 1% today,” they usually mean the S&P/TSX Composite Index rose 1% today.

The Dow Jones Industrial Average, the S&P 500 and the Nasdaq 100 are examples of indexes that measure the US stock market. You may have heard of the Nikkei 225, the most popular index of Japanese stocks, or the FTSE 100, which tracks the market in the UK. Other indexes measure the fixed-income market, such as the widely used DEX Universe Bond Index, which covers both government and corporate bonds in Canada.

An index mutual fund holds all (or almost all) of the stocks or bonds in a particular index. The idea is to produce a return equal to that of the overall market, as measured by the index. That’s different from the goal of “actively managed” mutual funds, which try (usually unsuccessfully) to pick and choose stocks that will outperform the market. To use a favourite phrase of John Bogle, the father of index investing, instead of looking for the needle, index funds buy the haystack.

What are exchange-traded funds (ETFs)?

Exchange-traded funds, or ETFs, are similar to index mutual funds in that they hold a basket of stocks or bonds and track a specific index. However, unlike mutual funds, ETFs are bought and sold on an exchange, like stocks.

While investors must pay a commission to buy and sell exchange-traded funds (just as they would when trading stocks), ETFs typically have lower annual fees than index mutual funds. They are also more varied and numerous, offering investors access to almost every kind of asset: stocks, bonds, real estate, commodities, precious metals, currencies and more.

Where does the Couch Potato name come from?

In 1987, Scott Burns, then a financial writer for the Dallas Morning News, began suggesting that investors simply put half their money in an index fund that tracked the stocks in the S&P 500, and the other half in a fund that tracked the entire US bond market. Every year, he said, rebalance the portfolio so it’s once again 50% stocks and 50% bonds. “You need to pay attention to your investments only once a year,” he wrote. “Any time it’s convenient. Any time you can muster the capacity to divide by the number 2.” He called his ultra-simple investment idea the “Couch Potato portfolio.”

When MoneySense magazine launched in 1999, founding editor Ian McGugan brought the Couch Potato idea to Canada. Since then, MoneySense has been a leading proponent of the strategy, and has created several Couch Potato portfolios for Canadian investors.

How can such a simple strategy beat the pros?

To many investors, the idea that the Couch Potato strategy can beat most professional money managers seems ridiculous—as though someone were selling a golf strategy that could beat most players on the PGA Tour. The difference, however, is that pro golfers routinely shoot under par, while most mutual fund managers underperform the overall market. For example, over the five years ending in 2009, 92.6% of actively managed Canadian mutual funds failed to deliver better returns than the S&P/TSX Composite Index.

Rather than paying money managers high fees to try in vain to beat the market, Couch Potato investors simply aim for market returns at the lowest possible cost. After all, no one needs to beat the market to be a successful investor. From 1980 through 2009, the average return of Canadian stocks and bonds was over 10% annually, including dividends and interest. Investors who earn returns like that should have no trouble reaching their financial goals.

Why is my advisor trying to talk me out of it?

Many financial advisors are downright contemptuous of indexing, even though it is used by the most sophisticated pension and endowment fund managers in the world, and many of its proponents are Nobel laureates. The reason is simple: most advisors make their money from commissions and fees on the investment products they sell. As Upton Sinclair wrote, “It is difficult to get a man to understand something when his salary depends upon his not understanding it.”

Most investment firms don’t even offer index mutual funds (they’re not profitable enough), and many mutual fund salespeople are not licensed to sell ETFs. That’s why a growing number of Couch Potatoes are choosing to build their own portfolios with online discount brokerage accounts.

How do I ditch my advisor and become a Couch Potato?

Start by opening an account with a discount brokerage, which will allow you to buy investments online. If you have your chequing account with one of the Big Five banks, that’s the easiest place to begin, as each has its own brokerage arm: RBC Direct Investing, BMO InvestorLine, TD Waterhouse, Scotia McLeod Direct Investing and CIBC Investor’s Edge.

If you’re not inclined to work with your bank, read the Globe and Mail‘s annual online broker survey to learn about the pros and cons of all major brokerages in Canada.

Another option (especially for smaller portfolios) is to open an online investment account TD, which offers a family of excellent index funds (e-Series) that are only available to its online customers.

You can set up your account as an RRSP, an RESP, a Tax-Free Savings Account, or a taxable account.

Then tell your financial advisor to sell all your current holdings—stocks, bonds, mutual funds—and transfer the cash to your new brokerage account. (It may be cheaper to transfer them “in kind” to your new account, and then sell them.) This will involve some paperwork and fees, and it may take a week or two. Your discount brokerage can help, and will often pay the transfer fee if you’re moving a large sum.

Once all the cash is in your new account, you can build your new Couch Potato portfolio with index funds or ETFs.

Should I use index mutual funds or ETFs?

The decision between index mutual funds and exchange-traded funds (ETFs) depends on the amount you’re investing, and whether you’ll be adding new money every month or depositing infrequent lump sums.

If you’re a monthly investor, or if you’re starting with less than $50,000 or so, you’re usually better off with index mutual funds. In general, they charge higher annual fees than ETFs—even two or three times more. But the trade-off is that you don’t pay any commissions when you contribute to an index mutual fund, so it’s easy and cost-effective to add a couple of hundred dollars a month—indeed, you can set up an automatic withdrawal from your bank account.

Annual management expenses are usually lower with ETFs, but you’ll pay a commission every time you buy or sell (typically about $29 at the big-bank brokerages, and $9.95 if you have a large account, or if you use one of the independent brokerages, such as Questrade). That’s fine if you’re investing big lump sums once or twice a year, but it’s ridiculously expensive if you’re adding a couple of hundred dollars every month. As a rule of thumb, try to keep your trading costs under 1%: for example, if you’re paying a $29 commission, an ETF purchase is really only cost-efficient if you’re buying at least $3,000 worth of shares.

For step-by-step instructions on making the calculations, see this post.

Which funds or ETFs should I use in my portfolio?

See our Model Portfolios page for suggestions.

Is there an easier way to become a Couch Potato?

If you’re looking for the easiest route to Couch Potatohood, consider ING Direct’s Streetwise Fund. You can invest directly through ING—there are no upfront fees, no minimum investment, and no need to open a discount brokerage account. The Streetwise Fund is available in three flavours (for conservative, moderate and aggressive investors), and each one invests in Canadian, US and international stocks and Canadian bonds using an indexing strategy.

The Streetwise fund charges an annual management fee of 1%. That’s more than you’d pay with a custom Couch Potato portfolio, but less than half what most mutual funds charge. If you’re investing less than $10,000 or so, it’s a great way to build your savings—and your confidence as a do-it-yourselfer.

For more suggestions on getting started, see my MoneySense article “Become a Couch Potato investor with less than $5,000.”

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