Why am I an index investor? Because I’ve cut too many government umbilical cords to be able to take silly risks with my money.
My entire personal portfolio (worth $1.7-million) is invested in the strategy I think makes the most sense for investors like myself – people who are fiercely interested in growing their wealth but have a realistic sense of just how difficult it is to beat the markets on a consistent basis.
That means I invest through index funds. No individual stocks. No actively managed mutual funds. Just a diversified, low-cost portfolio of exchange-traded funds. As Strategy Lab unfolds, I’ll recommend that you invest similarly. And I’ll serve as your guide.
Let me introduce myself: I’m a 42-year old Canadian school teacher currently residing in Singapore. Over the past couple of decades, thanks to hard work, a frugal lifestyle and some smart investing, I’ve been fortunate enough to amass a seven-figure net worth on my teacher’s salary. The downside is that by moving away from Canada, I’ve relinquished my British Columbia teacher’s pension and hammered my Canada Pension Plan potential. Without a social safety net, I need to invest as responsibly as possible.
The biggest single reason to invest like I do is that nobody – not even Warren Buffett, not even Mark Carney – knows where the stock markets are headed over the next year or over the next 10. Indexing means you don’t have to guess. You simply take what the world's stock and bond markets provide, by purchasing exchange-traded funds that track benchmarks like the S&P/TSX composite (for Canadian stocks), a bond market index (for Canadian bonds) or the S&P 500 (for U.S. stocks).
Doesn’t sound very exciting, does it? History shows, though, that if you follow an indexing strategy consistently over a couple of decades, you’ll thrash the results of most professional investors while spending less than an hour a year monitoring your money. No stock picking guru can promise you that. And if they’re honest, they’ll admit it.
Indexing shines because it’s cheap – unlike most actively managed mutual funds. Many Canadians who invest in the stock market through mutual funds pay more than 2 per cent each year in mutual fund costs. That is nosebleed high by international standards. If the investment world had a wall of shame, our funds would top the chart.
The high fees drag down investing results. Even if an active manager succeeds in beating the market by a percentage point or two before expenses, the hefty costs are likely to pull him or her below the index results.
This is not just theory. Standard and Poor’s reports that 97.5 per cent of actively managed Canadian stock market funds underperformed the Canadian stock market from 2005-2010, thanks largely to the funds’ management expenses. Most U.S. studies suggest that about 80 per cent of actively managed funds trail behind their benchmark indexes over a period of 10 years or more.
Consider what would happen if the Canadian stock market averages an 8 per cent annual return over the next few decades. The average Canadian stock market fund would make 8 per cent, minus the cost of running the fund – typically around 2.5 per cent. That means a typical investor would reap an average return of roughly 5.5 per cent.
In contrast, a cheap Canadian exchange traded fund can be had for an annual cost of just 0.1 per cent. That would leave roughly 7.9 per cent for the index investor (based on the same 8 per cent market return minus 0.1 per cent in fees).
Over 40 years, there’s a giant difference between making 5.5 per cent and 7.9 per cent. Do the math: investing $300 a month for 40 years at 5.5 per cent annually turns into $518,828. In contrast, the same amount invested for the same period at 7.9 per cent annually turns into $980,160.
Could you do even better by wisely picking individual stocks? Maybe. I’ve done it myself with considerable success – but only by devoting countless hours to reading balance sheets and checking out specific companies. I stopped when I realized how unlikely my odds of continued success were, even with all the work I was putting into managing my portfolio.
As I began to read more widely about the theory of investing, I grew convinced by the mountain of academic research that shows how difficult it is to beat the market consistently. I’ve come to believe that a low cost, diversified portfolio of indexes will produce results over the long term that will overwhelm those earned by most active investors — if you’re patient enough to let it happen.
Securities mentioned in this article: