In a recent post titled Why this is no market for Couch Potatoes, Balance Junkie took issue with a recent column in MoneySense magazine (See A cure for Potato performance anxiety, June 2011). In his magazine column, Canadian Couch Potato argued that passive investors should stick with their plan even though index portfolio returns in the recent past were rather modest. The Global Couch Potato composed of 40% bonds and 20% each in Canadian stocks, US and EAFE stocks returned 4.0% (or 1.2% in inflation-adjusted terms) in the 2001-10 time period. The irony here is that most average investors I know would look at their own portfolios devastated by expenses and performance chasing and gladly take 4% over the past 10 years. Still, Balance Junkie says that in a secular bear market, a Couch Potato strategy is not effective:

I have written over and over again that we are in a secular bear market that began in 2000. If you took that into account, you wouldn’t be at all surprised to see below-average returns for the Couch Potato portfolio over the last decade. The 20-year period before 2000 was a secular bull market. The Couch Potato approach would have worked beautifully during that time period, but it won’t be effective in a secular bear market.

First, it is not true that all Couch Potatoes are invested 100% in stocks all the time. As a (relatively) young investor with a spouse who has one of those nice defined benefit pension plans, we have a 20% allocation to bonds in our retirement accounts but an older, retired Couch Potato might have 100% in bonds. The point is a Couch Potato takes risks she is able and willing to take.

It should also be hardly surprising that investors with the bulk of their funds in the stock market experience poor returns from time to time. For instance, in the 10-year period 1973 to 1982, the Global Couch Potato would have returned 9.43%. That sounds great, except that the returns work out to just 0.85% in real terms. (And just an aside, a Couch Potato who persisted with the strategy would have earned 9.67% in real terms over the next decade). It is true that an investor who can nimbly move out of assets before they start underperforming and into assets before they start outperforming can do much better. There is only one little problem: the average, retail investor has pretty much zero chance of doing it consistently (and the record of professionals after fees and expenses isn’t anything to write about either).

Third, a well-diversified Couch Potato already takes advantage of market fluctuations by rebalancing her portfolio. Anyone can pull up a long-term chart and see for themselves that stock returns (at least in certain markets) since 2000 haven’t been great. It is much harder to correctly anticipate market conditions and adjust one’s portfolio accordingly. So, those who aren’t happy with Couch Potato returns should ask themselves: Were my returns any better? Was it skill or merely luck?

This article has 23 comments

  1. It seems to me that indexing strategies primarily invest for capital gains and of that’s what you’re after then indexing is a great way to diversify risk.

    For me, I invest for yield, so I would have to screen out stocks that don’t pay dividends and on fixed income I protect my principal by buying individual bonds and GICs – and put them in tax advantaged or tax deferred accounts (where you can’t write off capital losses such as RSPs and TFSAs)

  2. I think you might be reading Balance Junkie’s post wrong… he’s not only complaining about the poor performance of equities in a couch potato portfolio; he’s also complaining about poor performance of the bond component.

    (In a follow-up post on his site, he addresses what he sees as more promising alternative investments, which seem to be (i) gold; and (ii) income-oriented investments like investment grade corporates and REITs.)

  3. You’re absolutely right when you ask “Were my returns any better”?

    The amazing thing is that among the bloggers at least, the couch potatoes are the only ones who track the returns.

    I can’t understand anyone doing any investing at all not tracking their returns.

  4. The argument about stock picking in flat markets seems to come down to saying that when returns are low you have to take chances to get higher returns. Never mind that most investors will get even lower returns than the already low market returns. This sounds about the same as the gambler who is behind and starts making bigger bets in an effort to break even.

  5. @Phil S: I would view a collection of dividend stocks to have more or less the same risk, return profile as a broad-based index. The total returns are likely to be more or less the same with dividend stocks providing more income and less capital gains compared to a broad-based index. For an income-seeking investor, a dividend portfolio is an excellent choice as long as they understand that they still own stocks, therefore the value of the portfolio will fluctuate, sometimes dramatically and dividend income from the portfolio is not guaranteed and could drop sharply.

    @Viscount: I looked up Balance Junkie’s follow-up post after reading your comment:

    http://balancejunkie.com/2011/07/27/portfolio-options-for-a-risky-market/

    I wonder what she’s smoking. First, she rips Couch Potatoes for investing in broad-based indexes and then suggests… dividend-paying stocks? Or suggesting avoiding bonds but asks readers to consider… corporate bonds? REITs? REIT valuations are quite stretched — they are trading at a premium to NAV and the spread over 10-year bonds is not very much. I’m speechless.

    @Mike: It’s a question that must be put to everyone who claims they can produce superior investing returns: Did you do any better? Usually, the answer to that question is no or coulda, shoulda, woulda. So what makes them think they can do any better in the future?

    @Michael: I agree. All this talk of market cycles reminds me of Harry Dent and Robert Prechter. They’ve made a few correct calls in their time but have been spectacularly wrong ever since. That’s the trouble with market timing. You never know when the train is going to leave the station without you on board.

    This isn’t an argument that valuations don’t matter. It’s just that couch potatoes strategies account for it through diligent rebalancing.

  6. @CC: Sounds like you and I were thinking along the same lines this weekend. :)

    The problem with so many critics of passive investing (including Balance Junkie) is that they do not offer an alternative disciplined strategy. This month it’s “stocks are too risky,” then it’s “bonds are in trouble.” Actually, sometimes it’s both at the same time. Today we act based on this market commentator, and next week we listen to someone else.

    It doesn’t have to be indexing. One thing I have always acknowledged is that dividend-growth investing is a disciplined strategy that involves staying in for the long term and not juggling the portfolio based on this or that forecast. I may not agree that it offers great hopes for market-beating returns, but if you stick to your plan you’re going to do well with it. I cannot say the same thing about investors who think they can jump in and out of asset classes based on soothsayers.

    • @Canadian Couch Potato: I agree that it’s not enough to bash a defensive investment strategy. One has to offer an alternative that (a) was demonstrably superior (b) provides good odds of future success and (c) repeatable by pretty much everyone. I don’t think riding market cycles satisfies any of these criteria.

      @My Own Advisor: In general, I agree with your comments but I do have a few quibbles. Sticking to a plan is a good idea only if the plan puts investing odds in its favour. IMO, I don’t think market timing based on secular cycles or whatever will work for the average investor (I don’t deny that it may work for some investors but then it’s up to the investor to figure out if they can ride market trends consistently well).

      I also disagree on the degree of work involved in stock picking. In my early years I was a stock picker. Today, I’m a Couch Potato. Stock picking is a very hard job. You have to stay on top of what’s happening with your holdings. You have to look at entry and exit points. You have to benchmark your returns and figure out if you are any good in stock picking. Couch Potato investing takes some work but not nearly as much. There is some initial work involved in coming up with an asset allocation and investing accordingly. After that, the only work required is to make sure the portfolio doesn’t veer too much from the targets. A quick look once every few weeks or so at a spreadsheet is enough.

  7. I thought Balance Junkie’s article was good, certainly from the perspective of contexting; using historical references to help understand what has happened with the markets and what can be learned from them for the future. But, beating up Global Couch Potato investors after our most recent 10-year investment window is a bit shortsighted.

    I wrote as a comment regarding timeframes and contexting on her blog: “The timeframe is everything really; you can spin any data to meet your needs if you pick the appropriate investment window. I’m not saying you did this in your article, rather, I find many financial articles don’t take this bias into account. While I like your point about contexting, (85-year timeframe vs. 25-year timeframe), choosing an investment window to articulate portfolio returns is something writers need to take into consideration when discussing returns. Even avoiding a few high-return investment days on the market is enough to skew data.”

    I’m a big fan of Couch Potato investing, in my RRSP in particular, and I don’t think it was Kim’s stance to mash potatoes so fiercely in the post but maybe I was wrong???. Maybe I missed her intent when she poked at the MoneySense article that stated the Couch Potato strategy was “the investing equivalent of flopping in front of the TV with a bag of Cheetos.” I agree with her it is definitely not that easy but I don’t think the MoneySense article said it was always easy. Rather, the MoneySense article said it remains a good way to invest (not the only way to invest…) because nobody has any way of knowing “whether the next decade will see higher returns, but we do know that index investors are better equipped than ever to capture everything the markets have to offer.” In this regard, Couch Potato investing makes sense and probably always will. I think looking at only the past 10 years and saying “investment returns it generated….were somewhat lower than advertised” is a shortsighted statement.

    I stand by Couch Potato investing for a major portion of my portfolio not just because how tons of data and reports support this approach but how my own RRSP portfolio has performed in recent years when markets were down, up, sideways and everything in between. I also stand by my belief that indexing is really no different than any other style of investing, you can’t just sit back and let the world fly buy – it absolutely takes some hands-on approach but certainly much less than others like dividend-investing and much less still than momentum investing. What Kim’s article didn’t explicity express is the approach matters less than sticking with the approach long-term itself which is a) probably more important than what you invest in and b) much longer than the 10 years Balance Junkie explained in her mashing the global potato post.

  8. CC this is a good post :)

    There is a complete absuridity to market timing, becuase it doesn’t work. People like to pretend they can, or they have a method that is better than others, but in reality they can’t. I found Balance Junkie’s posts both full of conjecture, but slim on facts, and with little indication to what her alternatives or strategy really is. My favourite line from her posts is the following:

    Balance Junkie writes:
    “The market is not my benchmark. My benchmark is zero.”

    I’m in my 40’s so my target allocation in bonds is 40%, and the rest is in dividend stocks or index funds. I view my dividend stocks the same way I view my index funds. By that I mean I invest in them passively, and when markets are “seeminlgy” down I purchase more shares or buy more index fund units. I’ve taken profit on some stocks, and I’ve been lucky in most of my picks (not all), but I certainly don’t see index investing as the only way to make money.

    I’ve come to the conclusion regardless of what strategy you embrace, that buy and hold for the long term is the only way to reap the rewards of your efforts. I even have mutual funds with great ROI becuase I have held them for the long term. Those who flirt in and out of the market becuase of “economic indicators” or whatever reason, are fooling themselves and often wrong. And those mistakes can be costly.

    Cheers
    The Dividend Ninja

  9. I didn’t think too much about many of Balance Junkie’s arguments, however, I do have a concern about the Couch Potato Strategy which concerns when/how rebalancing occurs.

    I take that there are 2 general strategies for rebalancing, (i) periodic – with no consideration of how the assets are performing, and (ii) a ‘value’-like approach, where rebalancing is done when holdings move outside of the pre-determined allocation, say by 5%.

    The argument against (i), like general arguments against dollar-cost averaging show that these methods DO work, only in bull markets, and that they under-perform lump sum investing in declining markets.

    Strategy (ii) also has pitfalls, specifically, this strategy assumes that the assets you select show some level of uncorrelatedness. There is some research showing how correlation coefficients can change dramatically over time, so there can be times where perhaps, we shouldn’t/needn’t hold bonds at all, if they begin moving in closer alignment to stocks. Many Potatoes follow the tenant that as one asset class increases/decreases, that the other assets are ‘valued’ better, which may not be true.

    The questions for Potatoes is whether these two factors can significantly alter their returns. These discussion always separate two groups, stock picker/market timers vs. ‘passive investors’, but surely there are further sub-classifications within each group. Someone holding onto a Couch potato portfolio, diligently DVA’ing may suddenly be holding a portfolio of closely correlated assets, and lose much of the benefits they assume to hold.

    • @Sampson: I haven’t seen studies comparing periodic rebalancing versus threshold rebalancing. But I have seen studies on how often to rebalance and the answer IIRC was that once every couple of years. I would imagine that threshold-based rebalancing would work out a little better in volatile market conditions but that’s just a guess.

      Yes, correlations can vary over time but I haven’t seen anything indicating that bonds and stocks have gotten so correlated that diversification is not useful anymore. In fact, stock-bond correlations in the US are decreasing. Even a correlation of 0.5 is low enough to make diversification useful. The last I checked the correlation between US stocks (without currency hedging) and Canadian equities is around 0.5 (don’t hold me to this because this is off the top of my head), so there is lot of diversification benefits even between different stock markets.

      http://www.portfoliosolutions.com/f-correl.html

      I think in some ways we are over thinking here because who knows what future correlations will turn out to be. The point is those who have a diversified portfolio should rebalance once in a while. They should pick a method and stick to it. Only with the benefit of hindsight will we know which method was better.

  10. I recently saw an article (not research mind-you) suggesting stock-bond correlations over the past 6-12 months was actually as high as 0.8.

    The research surrounding tactical asset allocation is low, and no clear evidence either way whether it is worthwhile, but surely these types of concepts make the ‘passive vs. active’ debate more gray.

    I really never understood why people feel a need to pigeon-hole themselves as following one or the other exclusively. This happens often in discussions regarding money. The truth is, each method has outperformed the other at times, and I understand the value of making these decisions more mechanistic and removing the psychological element and the need to time and pick perfectly – I guess people get defensive when they are told what they do and believe is not the best way to go about something. Money is money, nothing personal 😉

    • @Sampson: Yes, we all have our little confirmation biases; we don’t really like to hear something that clashes with our orderly world view. But what Balance Junkie is promoting is essentially tactical asset allocation. I haven’t seen any studies that shows that it works either for professionals or for individual investors. That doesn’t mean it won’t work for anyone; just that your average investor who decides to go tactical has odds stacked against her.

      Even Ben Graham who essentially advocates a tactical asset allocation of between 25 to 75 percent stocks in The Intelligent Investor, recommends investors don’t go below 25 percent on either the stock or bond portion because their guess of market conditions could turn out to be wrong. I think some tactical asset allocation in the form of tweaking the asset allocation here and there is likely harmless (though I do think it’s more likely than not that it won’t work). But selling and going 100% to cash in the hope of jumping in again in the future at a given level is not wise, IMO. Stocks may never get to that level and an investor may end up holding cash for a very long time. And likely will jump in again at the wrong time.

  11. I recently saw an article (not research mind-you) suggesting stock-bond correlations over the past 6-12 months was actually as high as 0.8.

    I doubt this is true for short term bonds which is what I use (XSB). I’m pretty confident that XSB and my various equity ETFs do not have a high correlation.

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  17. I utilize the tool at the Claymore Site, it allows me to input my personal ETF Allocation, then allows me to compare to its’ performance versus the overall market, Royal also has a neat tool that allows you to input your Portfolio expectations and compares your actual mix to a model portfolio.
    I will take a 4% return for the next few years, but when rates rachet back up to double digits, i expect to be very overweight GIC’s.

  18. Hi Canadian Capitalist,

    This is a great debate! How involved does an investor need to be in order to be successful with their investments? Do you think that the new proposal from the Securities Commission to make posting of fees mandatory will make a difference in investing tactics whatsoever? http://ow.ly/66LrG

    • @GetSmarterAboutMoney: I think it is best to leave investments alone as much as possible to get the best results. Yes, one does need to keep track of asset allocation to figure out where new savings need to be channeled or to rebalance but being too involved in investments too often makes it tempting to do something instead of sitting still. I see this as a huge appeal of couch potato investing… it reduces some of the decisions investors have to make such as should I go with Manager A or Manager B.

      The new proposal from the securities commission is interesting. Thanks for the link. I’ll probably make a submission after organizing my thoughts. I’ll also post it here on the blog.

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