[Today’s post is a guest article by a reader who prefers to be called Phil who wants to hear some critical commentary and constructive feedback on his portfolio. He feels that a lot of readers might be in his situation — a recent convert to DIY investing but with a lot of mutual fund investments that are underwater and would benefit from a discussion of his portfolio. The second part of the post will run tomorrow. Over to Phil…]

The idea for this exercise was generated after reading the very popular Amateur Investor Manifesto series of posts in December. I think all readers of the blog benefited from seeing Reader J’s thought process and the reasons behind his asset allocation. One of the things that I thought was missing, however, was a discussion about how to split the allocation across the different types of accounts that are available to Canadian investors (e.g. RRSP, TFSA, RESP, non-registered account, high-interest savings accounts, etc). The other big difference between Reader J’s situation and mine (and perhaps many others’ out there) is that I’m looking to make changes to an existing portfolio (which, courtesy of my former advisor, is weighted about 90% in equities and is down about 28%).
What I’m hoping to get out of this post is candid feedback about where you think I may have gone wrong with my investment strategy, and where you think I can improve.

Background
My wife (Bonnie) and I (Phil) are both 33 years old and we both work full-time. We do not have kids but we hope to start a family within the next 12 months.

Objectives/Constraints
Our main short term goal is to save enough money to buy a cottage. Over the longer term, our goal, like that of most Canadians, is to save enough to live comfortably in retirement. I would like to retire at 55, my wife would like to retire from full-time work at 65 and continue working part-time. Roughly 50% of our monthly after tax income is required to meet our monthly expenses. The remaining 50% is free for investing.

Asset Allocation
Our target asset allocation is 50% Equity, 32% fixed income, 2% cash and 16% alternative investments.

History
We have been investing since 2007 (up until that point any excess savings we accumulated simply went to debt repayment – we both had large student loans). We spent two years (February 2007 to May 2009) with a Scotia McLeod advisor whose main recommendation (which we followed) was to devote 100% of our monthly RSP contributions to the LifePoints Long Term Growth, a “fund of funds” mutual fund with a heavy (80%) equity focus managed by Russell Investments Canada. The fund has a 2.5% MER and the NAV as of mid-June is about 28% below our average cost. Needles to say, we are very disappointed with the fund’s performance, but we need look no further than ourselves for someone to blame. And to be fair, the fund is not the worst performer in its category. In addition to our monthly RSP contributions, our advisor also recommended that we start a non-registered account, with a starting position of 5 blue chip Canadian stocks (see portfolio section in Part 2 for details).

The advisor got paid by taking one quarter of 1.5% of the market value of our portfolio every three months. In truth, I’m not sure that the advisors’ fees were greater than the trading fees that we would otherwise have incurred had we been investing with a self-directed account. However, we recognized that as portfolio grew every month, the fee-based relationship with our advisor became more and more expensive. The other problem we had was lack of control (i.e. we couldn’t make the trades ourselves and had to call them in real-time, etc.).

While still under the advisory relationship, we took over management of our portfolio in mid 2008 and immediately shifted into ETFs. This was interesting to me because we were in effect eschewing the advisor’s advice yet continuing to pay for it! I’ve been a proponent of passive investing ever since reading A Random Walk Down Wall Street. We completely terminated our relationship with the advisor in mid-June and are now DIY investors with Scotia iTrade.

While we’ve been generally happy with the new direction we set for our portfolio, there are a lot of uncertainties ahead. Our first concern is how to intelligently balance our portfolio. The challenge is that our portfolio has never been balanced, and we’re starting the process in the midst of a recession where most of our equity holdings are underwater. Clearly it’s much less painful to balance a portfolio when one can sell one’s holdings for a profit. Should we continue to buy equities at what could turn out to be historically low prices? This would drive down our average cost and position us well for a market rebound. Or should we buy fixed income to balance the portfolio? And should we buy bond funds or individual bonds?

A second challenge is how to allocate our various positions from a “tax advantaged” perspective across the six accounts that comprise our portfolio. For example, I’ve read that it’s best to hold fixed income in one’s RSP and Canadian equity (especially dividend paying stocks) in one’s non-registered account.

Finally, there’s the issue of our units in the LifePoints mutual fund. It comprises the bulk of the value of both my and my wife’s RSP. Should we buy more units to lower our average cost and speed up our breakeven point (at which point we would likely redeem our units)? This would seem to be throwing good money after bad.

Other issues: are we holding too much USD in our portfolios (e.g. Vanguard ETFs?) The short to mid-term outlook for the US dollar is not pretty. Should we bother at all with GICs? Are the Claymore sector ETFs (e.g. water, agriculture, etc.) too thinly traded to be useful as a long-term investment?


Continued in Part 2

This article has 23 comments

  1. I’m not going to offer advice other than to say I wish more Canadians would take control of their investments and put the necessary effort into constructing a cost efficient portfolio. Unfortunately too many Canadians are intimidated by the process of selecting investments and monitoring their accounts.

  2. Hi Phil, congrats on going DIY. I commend you on your bravery! The following are my opinions only, and you may want to consult with a fee based financial professional (or other experts around the blogsphere) to get a second opinion.

    On asset allocation:
    If you are continuing to invest, you may want to try to balance back your portfolio slowly through your regular contributions. You need not rush and have a perfectly balanced portfolio right away. If you are overweighted in equities right now, you might want to consider buying fixed income to “cushion” your portfolio (though safety is expensive right now). There is no perfect asset allocation and as long as you’re not selling at a loss due to emotion (it sounds like you are selling at a loss due to a need to rebalance) you’ll be fine. For more information on asset allocation, I highly suggest reading “The Strategic Asset Allocator” by William Bernstein.

    On fixed income:
    There is some great value out there in the corporate bond market. With an individual bond, you are subject to the risk of that the company may default. In addition to that, if you plan to sell the bonds before maturity, you may suffer a loss depending on how much interest rates go up (reminder: they are at historic lows currently). By holding a bond fund or an ETF, you may have less chance of losing money because there’s so much more companies that would need to default before it really affects the value significantly. There are index bond funds / ETFs available out there as well.

    On tax:
    All interest on bonds and GICs are fully taxable. Dividends from Canadian companies are taxed slightly more favorably because of the Dividend Tax Credit. Capital gains are the most tax efficient. Ideally, you would have more bonds / GICs in RRSPs and TFSA’s and more equity in taxable accounts, but it really depends on your own tax situation. If you have not maxxed out your RRSP / TFSA and you are in a relatively higher tax bracket, it might make sense to max out the registered plans before even considering non registered accounts. If everything is tax deferred, then there is less tax drag on the portfolio.

    On your existing LifePoints units:
    My suggestion in regards to your LifePoints funds is to sell them immediately as long as you are not penalized for any additional fees (i.e.: frequent switching or DSC). These funds are charging you high fees everyday; you can “average down” with other investments. By purchasing more LifePoints to “average down,” you will be paying more fees. These price level of the equity component in these funds reflect the market, but so are the index funds / ETFs you are purchasing. You are still buying back equity at a low price (averaging down), but not paying the fees. Said another way: paying more fees is not going to help you get your old fees back.

    On the other questions:
    GICs are great if you know you will have to use the money in a year or two. They aren’t paying much right now, but it’s better than getting no interest at all. Alternatively, you can park your funds in a high interest savings account. If you are truly focused on investing for the long term, the liquidity factor shouldn’t really matter until you need to sell (hopefully you’ll give yourself some time). Those ETFs should be liquid enough for you to sell as I think there are speculators out there who do buy and sell these on a daily basis.

    Good luck and keep us posted on your progress Phil!

  3. You should definitely read this study. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=962461

    Depending on your comfort level, you might want to weigh more equities and alternative assets and use quantitative techniques to miss market corrections.

    By the way, I think Scotia iTrade is a great discount brokerage and I want to do review on it.

  4. Charles in Vancouver

    On LifePoints: I agree with Howie but I have a particular suggestion. Check out the fund’s allocation to US, Canadian, International equities and to fixed-income. If you want to maintain the same equity exposure (to allow for a rebound) as you had inside the fund, simply sell the fund and purchase low-cost index funds / ETFs that approximate the fund’s composition. This way you are escaping the high-fee fund but you’re technically not “selling low” because you haven’t divested from the equities.

    On asset allocation:
    If you own more equities in total than you feel comfortable with, but you’re worried about selling low to rebalance, your fears are understandable. If your preferred way is to put new money into fixed income, you’ll benefit from any market upside without risking the new money in case things get worse.

    Depending on your comfort level, the idea of choosing fixed income other than government bonds / GICs / cash has some appeal (especially with historically low gov’t bond yields) but just be sure you understand the products you are buying, the inherent risks, the embedded options, the liquidity, the seniority of the debt. Corporate bonds, preferred shares, real return bonds and the funds that invest in them are examples of alternative fixed income.

  5. +1 to what Howie said. You can bail on the high-cost mutual funds right away and switch to ETFs, there’s no sense in waiting for them to go back up when the ETFs you’ll switch into will go up even more (i.e.: the same as the market, but with less fees). You can carry-forward the capital loss to offset capital gains later on, so it doesn’t even matter from a tax perspective. [Though of course, if there’s a back-end fee, then that changes things]

    “You don’t have to make it back the same way you lost it.”

    Personally, I wouldn’t rebalance as part of the sale — you’ve only got ~2 years of savings in there, so you might as well stay in equities in case there is a further rebound. You can increase your fixed income portion with new money (and it won’t take very long at all to get from ~20% to your target of 32%).

  6. Hello Phil,
    Congratulations on ditching the advisor who took fees to put your money into holdings that charged additional fees.

    How these guys expect there to be any profits left for you is beyond me.

    My advice is to do something different. Something safer. Something less risky. Something that nobody else here recommends. They all try for variations of the Prudent Man rule – which is not only obsolete, but I defy anyone to tell you who is qualified to speak for that Prudent Investor.

    1) “Clearly it’s much less painful to balance a portfolio when one can sell one’s holdings for a profit.”

    Forget that stuff. Here’s the truth that few recognize. Your goal is to make money from today going forward. Where your holdings once traded has zero significance. Either you want to own those positions at today’s price, or you don’t. As a passive investor, you should not be making too many such decisions.

    2) Balancing your portfolio is far less important than you have been led to believe.

    3) As a do-it-yourselfer, you are in position to take charge and protect your assets from any more nasty draw-downs.

    Never again will you suffer as in 2008.

    I strongly suggest that you consider protecting a significant portion of your portfolio (or even all of it). When I say ‘protect’ I mean having a guarantee that the value of your holdings cannot drop below a certain level – a level chosen by you.

    In order to accomplish that without paying so much that it would be a foolish undertaking – you want to learn about adopting a collar position. And you can do it with passive investments – such as your ETFs.

    You buy puts. That sets a minimum value for your holdings. You have purchased the right to sell your ETFs at a given price, no matter how low they may decline. And you don’t have to sell. You certainly hope the ETFs don’t decline in value. But you have the right to sell – and thus, no more big losses for you.

    Next you sell calls. That provides the cash to pay for the puts. But, that also limits your upside. You have established a maximum value for your ETFs. If they move higher than the agreed upon selling price (strike price), you earn no additional profits.

    That’s the trade-off. Guarantee of no large losses. To pay for that insurance, you must agree to accept a limit on your profits. This is a great deal – for those who understand.

    One point: Do not skip selling the calls and decide only to buy puts. That is far too costly and makes it virtually impossible to make any money. Don’t do half the collar. Please.

    Look at the benefits: No bad losses – ever again. What you sacrifice is the ability to earn large, quick profits. But, it’s worth it. You have many years to accumulate wealth. That wealth comes from additional contributions to your savings, profits when the market rallies or holds steady, and no large losses. You will outperform the market most of the time, failing to beat the performance you would have obtained without collars, only when the market rallies strongly. But even then you will show a profit.

    This is the investing method of the future, but too few recognize it today.

    Learn how to use options then decide for yourself.

    http://blog.mdwoptions.com/options_for_rookies/

  7. Phil:
    I suggest you pay off all your debts , forget about a cottage , if you have to get away from city life , rent one.
    Buy Canada Savings Bonds and forget everything else.
    Don’t get caught up in all the hype – it is not a level playing field – you will not win.

  8. Hi Phil,

    When you’re talking about the “whole picture” then there’s so much information to cover and some of the other responders have tried to cover everything. I just want to point out some alternatives in terms of saving for your future cottage hunting… Owning a second property doesn’t allow you any of the benefits that you would have for owning your primary property. I don’t know whether you’ve considered this, but here is something to think about…

    What if you ran your cottage like a property rental business? For example, open a corporation, put money into the corporation, then have the corporation buy the property and rent it out. In that way, any interest earned on investments when you’re capitalizing your corporation isn’t attributed to you – so for example, before you buy the property, if you save $50K in your corporation and it earns $2K in interest, that $2K in interest isn’t attributed to your personal income, it is the corporation’s profits. After you buy the property, you can deduct maintenance and repair expenses as well as depreciation and mortgage interest. You rent the property from your corporation, but you can also rent out the same property to your friends, co-workers and acquaintances for the times when you’re not using it. It also makes it easier to transfer ownership to your kids when you eventually have them, in terms of succession planning – they can buy it from you a little at a time or whatever you want and it can be split evenly among them.

    Since buying a cottage can be an inconsistent timing thing (you don’t know when the right property comes up for sale or whatever other conditions arise) then I would suggest only investing in high liquidity interest bearing investments, such as high interest savings accounts or cashable GICs. The right property might not appear this year or next, but if it happens in 2011, then you want to be able to quickly raise the cash to make the purchase, not have it locked in an uncashable GIC or be in a down position on a stock or whatever.

    Sincerely, Phil

  9. My advice is that if you’re saving for the short term don’t put it in the stock market!

  10. Canadian Capitalist

    My thoughts:

    (1) Though I think that a cottage doesn’t make much financial sense, it is a personal decision. Some love it; others don’t. Vive la difference!

    (2) I don’t think you should compare trading costs of a DIY portfolio to LifePoints MER. The mutual funds in a LifePoints portfolio incur trading costs that don’t show up in the MER but they are funded out of the fund’s NAV. I recall Bogle estimating trading costs for mutual funds at roughly 1/100th of portfolio turnover. So, if a mutual fund turn over is 30% (which would qualify as a very low turnover fund), it is costing you 0.3% in trading expenses.

    (3) Regardless of (2), I disagree that trading commissions would cost you 1.5%. If you keep trading costs down to 1% of your initial investment and it is amortized over a very long time, trading commissions will be very small. Personally, my trading commissions run at roughly 0.2% of portfolio value every year.

    (4) Given that you’ve decided to exit LifePoints funds, I agree with Howie and others that it doesn’t make much sense to add to it. You have two options for exit: (i) Sell immediately (provided they are not DSC funds) (ii) Sell over time, especially if penalties are involved. Either way, it doesn’t make much sense to keep adding to a fund that you are planning to exit.

    (5) Again there are a couple of ways to bring your portfolio into balance: (i) Rebalance immediately. (ii) New investments are made according to your target allocations and rebalancing would be done gradually over time (iii) Rebalancing is done through new investments.

    I chose (i) when I went from 0% fixed income to 20% in 2007. If you choose (i) today, you may be making your portfolio more conservative when stocks are relatively attractive. (Yes, I know this smacks of timing, so the guess could be totally wrong and the recent peak could turn out to be the high for a while). This isn’t an easy call and you’d be lucky to make the right call.

    (6) With self-directed accounts, it should be fairly easy to keep investments in tax advantaged locations because you can simply swap securities of equivalent values between different accounts. Of course, there are tax implications in swapping with an investment account. Typically, bonds and foreign stocks are best kept in RRSPs. Due to withholding taxes, RRSPs are a better location for foreign stocks than TFSAs. Provided there is no more room, Canadian stocks are suitable for taxable accounts.

  11. I’m slowly working up to as non-correlated a portfolio as I dare. I’m 36 and willing to be aggresive. It seems to hedge your bets and have a core portion of your investments be “passive”, but take the time to consider high quality stocks in various sectors. For example, and this is just an example, you might have 1/2 to 2/3 of your savings equally spread between U.S., Canadian, and International ETF’s or low cost mutual funds. The remaining amount should be in indvidual stocks.

  12. Gaby,

    I get what you want to own.

    But why would you want to own them unhedged? Do you believe the markets are never going down again?

    Do you believe that by the time you retire you will have earned more than 10% per year – returns we took for granted just a short time ago?

    I’m not criticizing you. I am trying to understand why options are ignored by so many.

  13. My apologies, I didn’t mean to imply that options were not on my radar. As I get a more mature and growing portfolio, I’ll definitely consider options (still not fully practiced/well versed in the mechanics of it, will pick up a Dummies book or go online soon).

    As for a long term goal personally, I plan to have at least 25% Canadian Index, 25% U.S. Index, and 25% Emerging Markets invested each month automatically. The remaining 25% I will place in more active trading such as options or outright purchases in those aforementioned various sectors. (I will only short if I have money I’m willing to lose, which for now, is none). As I said earlier, I’m still getting more comfortable with some of the more interesting ways of investing, such as options and I feel, especially with the sideways market may folks are predicting will continue for awhile, that options will be a good thing to consider.

    If I don’t find anything interesting, I’ll bank the remaining 25% equally across the three passive components or hold some in cash bonds. As you can see, this is a fluid allocation but can be summarized as saying have at least an equal amount of the three passive components up to a toal variable percentage of my portfolio.

    IF, and this is will depend on many factors, but IF I become more confident in my stock selection skills based (we’re talking value investing here), I’ll pare the passive part down to maybe 60% total (20% each component) and have 40% active. Who knows, if I become the next Benjamin Graham or Warren Buffet, I’ll go 100% stocks, but let’s say that won’t happen for awhile. 🙂

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  15. The first thing I would do is figure out whether there is going to be a cost (penalty) to sell your current funds. Even if there is a penalty, you should weigh that against the underperformance of the fund (versus an index). Ie if you need to pay $500 to get out, but the fund is underperforming by $300 a year and you’re not able to get out without penalty for another 3 years, it makes sense to just sell it. This is the take home message: at some point the markets will start moving up again, and when they do you want to be in the most cost-efficient portfolio you can so you get the best bang for your buck.

    If that’s the case, you then need to decide on your bonds/equity split. At your age you should probably be 30-40% bonds, but obviously the timing isn’t fantastic right now to do that. I am a DIY passive investor but allow myself to provide some rationale into my approach. At your age I would increase my bond exposure to 20%, leave 80% in equities to capture as much of the upside as possible, and invest any new money into bonds until either it reaches its target or a specified amount of time has passed (ie give 2 years for equity recovery then rebalance).

  16. Hi Phil,

    Congratulations on taking the plunge into DIY investing. Since you are just starting out I would advise you stick with the basics (equities and fixed income) for now.

    You’ve chosen one of the most challenging times in quite a while (in my lifetime, anyways) to invest. Government fixed income is offering paltry rates of return, and carry a significant risk of loss should inflation rear its head. Meanwhile equities, after the current rally, are arguably quite expensive.

    Given this challenging investment environment, you’d be well served to consider what Kannucker mentioned about paying down your mortgage and other debts. If your mortgage rate is 5%, you can earn a guaranteed 5% by paying down the principal. In my opinion you’d be hard pressed to earn that in a conservative, balanced portfolio under these circumstances. Best of all, there’s no fees (provided you have a mortgage that allows this sort of thing)! It’s good to hear you’ve paid down your student loans; that’s a very smart move.

    If you are still dead set on investing additional funds, you could sitll contribute to RRSPs and use the tax refund to pay down your mortgage principal.

    Re: balancing, as CC said, you can either rebalance by actively selling an existing position to buy another, or by ensuring all your fresh contributions go the underweight share until you’ve reached your target allocation. If your regular contributions are a small percentage (say <1%) of your total portfolio, and your allocation is out of whack by say 10% or more, you may want to go with option number 1. Don’t get hung up on maintaining a perfect allocation at all times; to do so would entail daily buy and sell transactions that would very quickly erode your investment capital.

    It’s difficult for me to give portfolio advice without knowing the size of your portfolio. For the vast majority of folks your age, it makes more sense to buy diversified bond funds then individual bonds. In this environment, be very cautious of inflation down the road. I’d advise you stick to bonds/bond funds with a short maturities – they are less volatile than long bond funds. If you want to juice your returns, consider including high grade, short-term corporate bonds. Most government paper is yielding little at the moment. Ishares has some good bond funds.

    I’d also go the passive route (ETFs) with equities. Pick a global equity allocation, and use ETFs to make it happen. I generally advise about 1/3 each to Can, US, and World. I wouldn’t put more than half in any category. In Canada, Ishares has some nice products for this purpose. I also like TD’s low fee offerings here, too. You seem to be concerned about the $US (as am I). Currency hedged ETFs are available that give exposure to the US and MSCI for a relatively low MER (however note the hedging is in addition to the MER).

    As you’re both working and looking to start a family, I’d stock with 100% passive investing for now. Even if you have the inclination, in all likelihood you won’t have the time to keep abreast of individual securities.

    Make a wise plan, be disciplined to stick to it, and spend an hour or two roughly once a quarter or six months to review performance, rebalance, and consider any changes to your plan.

  17. Gaby,

    Please do not misunderstand me. I was NOT suggesting that you ever BUY options as a speculation. I strongly advise my readers against buying options or using them for gambling.

    I was suggesting ONLY conservative – risk reducing – option strategies, such as the collar. Buy whatever assets you want, but protect them – or at least that’s my message.

    Best of luck to you.

    Here’s an example of how a collar works:
    http://tinyurl.com/lwxo4x

  18. I’ve been investing for 21 years.
    The markets are far too volatile these days.
    You are relatively new to investing.
    Therefore, stay out of the markets and stay in cash.
    Learn – read books, etc.
    Especially be careful of blogs like CC who have very fixed, and IMHO, very wrong views of investing.

  19. @ All, many thanks for your comments. I look forward to receiving more from Part 2, which discusses security selection.
    @ Howie, thanks for the tip about the Bernstein book. The main disadvantage I see with bond ETFs is that they put your principal at risk. As for the Lifepoints, yours and other posts have made it clear that I should seriously consider selling it now! There are no DSCs.
    @Charles in Vancouver, thank you for the idea about replicating underlying indices of the Lifepoints fund. I agree that corporate bonds are an attractive asset class – the problem is that I have a lot to learn about understanding the complex features (e.g. callable, etc.) I think it’s better to build a bond ladder with bonds that are not callable.
    @Potato, I won’t be able to harvest the capital loss b/c it’s in an RSP. But I still think selling at a loss is the way to go. Like you said, “YOu don’t have to make it back the same way you lost it.” WHile buy and hold is a simple and easy-to-implement strategy, I’ve become convinced that a better approach (even for long term investment horizon) is to use stops or, even better, trailing stops.
    @Mark Wolfinger, thank you very much for the suggestion to use collars. I’m going to read more about this strategy. I won’t want to get involved with buying/selling options until and if I fully understand them. I’ve made the mistake before of buying something I didn’t fully understand (leveraged ETFs from Betapro!)
    @Phil S, thank you for suggestion re: cottage. I’ll have to look into that possibility.
    @CC, thanks for your insights into rebalancing. I think the way to go is to devote all fresh contributions to fixed income. I’ve got a few (perhaps too many!) lines in the equity waters.
    @MJ, paying down debt is a personal preference of mine. We recently refinanced and locked in at a pretty reasonable rate, but I still like to pay down as much as I can. And you’re probably right, with a family in tow I doubt I’ll have enough free time to pen guest articles to the CC website to get investment advice so better get the house in order now!

  20. Best of luck on your DIY investing.

    For what it is worth kids change everything. Your cash flow may change drastically for a long period of time, especially if one of you is going to be a stay-at-home parent for 5-7 years to raise the kids until they start school.

    Try adjusting your budget to survive on a single income and see how your wants vs needs may have to change. It hit me harder than I thought it would, especially keeping a mortgage and car payment as the only debt. Everything can scale if you work at it hard enough.

  21. Mark, I definitely will forego speculative buys and I don’t consider options speculative, just something I don’t have enough experience with, hence my taking time with it.

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  23. Regarding the cottage – think twice before buying. They are a lot of work – similar to a second home. Unless you have a lot of holidays (ie teacher) or can buy the cottage very close to where you live (and can use it a lot) then you might find that you end up spending most of your holidays doing work at the cottage.

    My parents cottage costs about $8,000 per year – this includes everything including satellite tv, bills etc. If you are only using a similar cottage for 4 weeks per year…well you can do the math.

    Another alternative is shared owning – I know someone who bought a 1/10 share of a cottage – the admin is run by some company. I think he pays $2500 per year for 5 weeks which are spread around the year and there is no work to do.

    The other drawback of a cottage is that it limits your holidays so you won`t be able to go to other areas or countries as much.