Today’s guest post, “Indexing is the Best Way to Invest Your Money” comes from Value Indexer. VI writes about enjoying wealth in all its forms at Simply Rich Life, and about index fund ideas and research at Value Indexer.
Indexing wasn’t my first choice when it came to investing. When I was a kid, one of the first books I read about money explained taxes, inflation, and investing (among other topics), all based on simple ideas to which a 10-year old could relate like having a paper route or running a lemonade stand. By the time I was 10 I thought bonds were really cool. Fortunately, by the time I had real money to invest I learned about index investing.
In a conversation with Joe, he asked me about a recent post where I talked about my goal to reach $500 in passive monthly income within the next year. Specifically he asked if my ‘passive income’ goal meant I was into dividend stocks. Dividend stocks were a phase I grew out of, sometime after bonds. Don’t get me wrong: I respect the strategy, it’s just not for me.
My portfolio is focused in a simple collection of index funds. Once we get a newly-opened RESP converted to access TD e-Series funds, that’s also where we’ll put education savings.
Yes, there are many good ways to invest. The best way is to use your money to start an active venture — opening a business, buying a rental property, etc. But eventually you want to slow down — and some people never want to ‘speed up’. The single most efficient passive investment is the use of low-cost index funds (indexing). (Editor Joe’s note: yes, as a reader of TimelessFinance you’ve seen this topic before. Take that as a hint. Also, VI brings some good ideas to the table that are new, at least on this blog.) Indexing can actually help you on the ‘active investment’ front, too — we’ll discuss that later.
Why is indexing so superior?
Adina talked about “financial Gandalfs“ when she wrote her indexing article. (Point taken but, upon review of the trilogy, I think Saruman is a more apt LoTR analogy for mutual fund managers. Saruman is smart, but he’s secretly serving his own interests and working against the protagonists.) These mutual fund managers tempt you to overlook their extraordinary fees and fixate on the possible fruits of their hyperactive investment strategies. ”Why settle for average when we can do better?” But this overlooks the truth that long-run returns from indexing are good if you stick with a solid plan. The passive returns from indexing are, ironically, above-average, because the average fund does worse than the market average after accounting for MERs and commissions. Money managers are paid huge sums to beat each other. It’s obviously impossible for more than half of the managers to beat the average. Investors pay the cost of this game of musical chairs. Canadians tend to be money-stupid about these sorts of things, putting up with fees that investors in other countries laugh at. In short, indexing costs less. OK, you already knew that. I promise I have a lot more ‘advantages’ to discuss and not one of them is the latte factor (so no worries, Adam P!).
But actively-managed mutual funds or financial advisors aren’t the only ways to try and skin the above-average cat. You can do your own fundamental research. You could stick to a dividend growth plan where you pick companies with a good record and let the dividends compound to pay you a tax-efficient income. These approaches sound interesting, can be fun, and may be quite profitable.
Yet in the long run they can’t beat indexing. Not on average. They have a head start against speculative investing or mutual funds — a dividend investor is usually focused on a long-term plan, allowing them to ignore market noise and making them more likely to buy low. Nevertheless, investing in stocks that pay eligible (tax-advantaged) dividends limits Canadians to a very small number of companies (care for BMO with a side of Telus?). That leaves a dividend fiend un-diversified. Remember: even good dividend payers can go bankrupt.
I prefer maximum diversification, which means broad index funds that cover a very high percentage of market capitalization. Index funds are the ultimate diversification tool. There’s hardly a large company in the world that I don’t own, so I don’t mind the occasional BP or Yahoo dragging us down. For each dud in my portfolio, there’s a famous company reaching new highs and, more importantly, many quietly-profitable companies.
Many of those profitable companies re-invest their profits instead of paying dividends. There’s another irony: a true dividend investor couldn’t buy Berkshire Hathaway. If you only buy dividend-payers, you don’t get any of these excellent companies nor any of their profits.
Some dividend fans point to the fact that dividends are real cash while earnings are just numbers on a spreadsheet. This is always a concern since there are countless companies that have pushed the earnings “game” too far or squandered real profits on subsequent bad decisions (e.g. Enron, Nortel, etc.). Nevertheless, the fear of immaterial earnings is, largely, immaterial. A recent report from institutional asset manager GMO summarized their research into how much of corporate earnings really go to investors. They built a model that said “if a company’s earnings are $x, the stock price should go up by $x over the next decade so investors can sell their shares and capture the profit”. When they compared this model to actual stock market performance, GMO found that earnings are overstated by a little over 1%. That means that if a company’s earnings are reported as 7.5% of the stock price, you can expect to eventually earn a real profit of approximately 6.5% from owning the shares. Index investors need to acknowledge this risk. Nevertheless, 1% isn’t a bad amount of leakage and leaves room for an awful lot of real profit. Also, dividend companies can be just as good with accounting tricks. If you’re a hardcore “cash is king” advocate, don’t forget: the best cash payouts come from early stage Ponzi schemes!
Speaking of scams, what really bothers me about day trading (or any “investing” strategies that aim to beat the market with hot tips, technical analysis, and capital gains) is that it’s a brutal version of office politics. Every gain you make above the index return must, by definition, come out of someone else’s account. Conversely, one powerful aspect of “settling” for the average is that it’s what anyone can get. The natural profits of corporations aren’t something you have to fight for. Why not? The people buying the products and services that create the profits get more value than what they pay. Because of this, they’re happy to continue paying. You just need to be willing to forgo the use of your money for a bit longer to grab a piece of those profits. On the other hand, making a day trading profit is only possible when you take money from someone else who is fighting to take that money from you. Some people might not be bothered by this — but everybody should be bothered by the fact that they have no advantage in such competitions. It’s just gambling.
Indexing has an air of predictability once you understand it. Not in the same sense as guaranteed-return funds — you don’t know what an index will return from year-to-year — but you can trust that the market will safely store capital. In the long run, it will generate profits for you. If that fails, you’ll need guns and canned goods, not investments. (Editor Joe’s note: sometime we really need to talk about the potential for a “lost decade”, as experienced by the Japanese, to devastate an index’s return; in such situations, heavy international diversification and dividends are the only defenses).
Indexing is also completely scalable. You can do it with as little as one fund (such as a Vanguard lifecycle fund). You can own four funds to diversify (but not overextend) a small- or medium-sized portfolio — this is my current strategy. If you’ve got a large portfolio, you can achieve plenty of diversification with just six to eight funds.
Best of all: once you set an indexing allocation, you can rebalance your portfolio with just a few minutes per year. There is no need to complicate things any further than you want to. Andrew Hallam is happy to manage a portfolio worth over $1M with only four funds, which won’t turn heads but will make lots of money with very little work. The simple fact is that if you take an active approach to stock investing, the work load is huge. It can really become more of a second (or third) job than an investment strategy. Sure, it could be profitable, but it’s not a good income to depend on. The cost/benefit analysis definitely favours indexing over active trading. (Editor Joe’s Note: another benefit of indexing is that it reduces your exposure to market bubbles — if you add money to under-performing funds, you’re usually “buying low” rather than buying into the asset or index that’s currently “hot”).
Now, as promised, let’s talk about how indexing helps you to actively invest. The benefit of passive investing doesn’t just stop at “you’ll save time by indexing!” It extends to what you can do with that time (and the associated peace of mind). Start a business, buy a rental property, or get better at what you already do for money. My business, like most jobs and unlike day trading, is non-zero-sum. People are happy to pay me because they get what they want at the same time. And if I give them extra value, they’re happy to pay even more. Why would I take on a second job as a trader to potentially make an extra $500 a month (assuming I don’t lose my shirt on bad trades) when I could focus on making an extra $30,000 a year in my business? Why would I spend 6 months trying to flip a house when I could earn just as much doing something I’m good at, while working fewer hours? (Editor Joe’s note: VI’s disgust for speculation is welcome on this blog! Capital gains and speculation are synonymous and are the worst kind of investing. Gold = real estate prices = Toronto condos = day trading. Don’t be an idiot.) When you’re considering an investment opportunity, don’t only worry about your capital input. Think about your time.
The way I invest is simple:
- Put in as much capital as possible; and
- Give it as much time as possible to grow.
Index investing makes it easy to execute my investment plan. It provides much better long-term returns than other passive investments like GICs. Unless you have over $1,000,000 in capital, your best way to earn more money is to let your investments manage themselves and to work on earning more from a side business. Then you can shovel more cash into your portfolio to increase your passive income.
What do you think about indexing? How do you invest?
Futurama = gold. “Once again, the conservative, sandwich-heavy portfolio pays off for the hungry investor.” – Zoidberg
I agree that passive investing is the way to go, the lower the MER the better, and that a long time horizon does wonders.
I was considering the PF take on investing the other day, weirdo that I am. It seems that the shift has taken us from actively managed mutual funds in the 90s (for diversification) to low MER indexed mutual funds in the 2000s (active funds rarely beat indexed) to even lower MER ETFs in the 2010s (the lower the fees the better!).
Very recently, the gurus I read are chasing yield by saying we should hold rate-reset preferreds of big banks and utility companies (lack of volatility plus tax friendly dividend income); or even income type securities that hold preferreds like “FIE” that yield 7% or so.
Funds that track the Canadian index have underperformed since the GFC, The US S&P500 has done much better. It’s no wonder so many Canadians are sinking all their net worth into the housing market, which is a terrible place to put it both for Canada and individually (see USA circa 2007). I’m with Joe, we need a housing correction big time.
Exactly. I know Garth Turner has been heavily advocating REITs over at GreaterFool. I’m sure he’s right as always, but I’m much more interested in bank dividends, which are pretty well CMHC-insured at this point. I also want to stay liquid, because I do want to buy a house.
I’ve actually looked at FIE before. I must say I wasn’t particularly impressed. The MER is 1% and a person could easily obtain the same holdings for a much lower cost.
I don’t practice what I preach in this regard but I’d definitely look at a high yield (junk) bond fund for some fixed income at a good rate (CHB is a quick example).
One thing I’ve never really understood about preferreds is why they don’t (or wouldn’t) behave similar to very long-term bonds, losing a lot of their value if interest rates or credit risks rise. If they are essentially the same as a perpetual bond (with payments that can be suspended at any time) they seem like they would react in a similar way. This may be the case, I just haven’t followed them enough to see.
The capital gain/loss can be insignificant to some people who only care about income/yield on what they purchased, locking in a ~6% tax preferential dividend may be okay for some people, like retirees. Unless we hit a period of prolonged double digit inflation (unlikely but maybe possible) then I would tend to agree. Once again, diversification is the key, as if rates go up your bonds/preferreds would tank but hopefully your equities would rise in tandem to mitigate the losses.
There are also rate-reset preferreds, which are a relatively new product and if interest rates go up they will be adjusted (usually every 5 years). Of course if you expect rates to go down, then you’d prefer perpetual preferreds.
I am so happy to read this post because it makes me feel better about my own investing “strategy”. That is, putting most of our savings into index funds (about 4 different ones for me, 2 for my husband who is more risk-averse) and focusing my time and energy on things that (a) I am far better at (than investing); and (b) have the potential to make me more money than I ever could by dabbling with investments. I have to admit, getting validation from a PF blog sure is nice
Although VI did a great job of explaining index funds, I still think that the simplest explanation for why index funds are the best option for folks like me is found in Dave Chilton’s Wealthy Barber Returns book. I highly recommend everyone read that particular chapter (though the whole book is worth a read).
P.S. VI, you are probably right on the LoTR thing … it’s been a while since I last read the books
Sounds like you’re on the right path Adina! As Andrew Hallam demonstrates, 4 index funds make a great strategy even for an advanced investor.
I don’t remember what the Wealthy Barber Returns said but I enjoyed reading both books a lot and being mentioned in the same sentence is a great honor
I hope the person who sold you mutual funds didn’t go the same way as Saruman!
Thanks for the opportunity to write a guest post Joe!
The Japanese experience is certainly something to look at. I haven’t looked too closely but it doesn’t seem like a highly diversified country (which applies to most countries 20-30 years ago). If most of the companies are focused internally or exporting in limited industries (see: TSX) then the market can be quite vulnerable. On the other side, the companies in the S&P 500 earn a lot of income outside the US (which could make it a better way to access emerging markets than actual emerging market stocks) and an index like the EAFE mixes in Japan with 15+ other countries so you don’t care too much what happens to any one of them.
As usual, proper diversification is the key. If your strategy depends on knowing what will happen with one investment in the next few years that’s active investing, even if you use index funds!
Indexing all the way. My favorite part is not needing to do research or watch the markets. I also don’t really see how much I have as a number of shares, but as a dollar amount. I think that helps to not freak out over market changes too. Plus: no trading fees, ever. (At the least the way I have implemented my portfolio.)
Buying individual stocks is gambling. I still have yet to step foot into a casino and I have no interest in gambling so strongly with my savings.
P.S. Andrew Hallman’s blog is amazing – thanks for the link!
When I first heard of “The Millionaire Teacher” I thought to myself — isn’t that all Canadian teachers who retire with a pension that has an actuarial value of like $1.5 million+? lol. But he actually teaches in more of a ‘free market’ environment which is interesting.
That’s the feeling I get whenever I think about other investing strategies. Why risk a big loss for a small potential gain? (and a lot more work)
Second post on index funds. Ok, I’m taking the hint Joe!
They’re a great way for a n00b to get into investing with only a few hundred a month!
Also, even though I strongly believe in index funds as one of two excellent stock investing options (I’m not as weary of dividend investing as VI), if this article didn’t offer anything new I wouldn’t have run it. But I was extremely impressed with all of the points — particularly the benefit of putting your investments on cruise control so you can focus on making more $$$ elsewhere!
Preach it brotha! I’m a huge Indexing guy as well. I even wrote a free ebook about it! John Bogle is my personal go-to in terms of quotes advocating indexing as a strategy. One small detail I will pick on is that ETFs have lower fees than the TD series (which is why Andrew Hallam uses them amongst others). If you are only investing small amounts, the TD series will likely win out because of fees, but overall you are usually always ahead with a portfolio of indexing ETFs over a lifetime. Small potatoes in the big picture though. Great article.
Fortunately we have a few good options here! The e-Series funds are great for anyone starting a small portfolio because it’s easy to set up monthly transfers to 4 different funds, and rebalance any time, with no fees (as long as you don’t sell units bought in the last 90 days). Once you have enough to go over to ETFs there are a lot more choices!
The article references that this method of investing is the best way to invest capital if you have less than $1,000,000.00. This suggests that there is a better method if you have a larger amount of capital. I am interested what this better method of investment is?
Also, what is the best method of implementing this strategy? Lump sum, DCA, Pyramid-up, etc? This is especially an important consideration if one is starting with a large amount of liquid assets but is important even if you are investing as you raise the cash flow…
There are a few things that are sold as better ways to invest large amounts, such as hedge funds, but have worse returns than index funds unless you get lucky. The actual better options are still fairly limited. It might be worth spending enough time to create your own market-beating investment strategy. It would involve a lot of work and anxiety but if you have $1M the extra returns could pay well for the time it takes. Or if you have well over $1M you could follow a passive strategy but buy individual stocks instead of indexes to get slightly lower fees.
For most people the only optimal method is to invest as much as possible every month as they receive regular income. In the rare cases where you have a larger amount available all at once, if you’re happy with today’s price you might want to buy in before it goes up. If you don’t like the price you could do dollar-cost averaging or dollar-value averaging to get the potential benefit of drops in the market. There is some research showing that the lost returns from delaying your investment are generally bigger than the lost returns from buying in at a slightly higher price (the longer you are in the market, the more profits you can earn).
There’s no guarantee that lower prices will come around in the near future. If you wouldn’t put 50% of your current portfolio in cash tomorrow and slowly move it back into the market, does it make sense to hold on to a windfall and only invest it gradually?