Take a trip to Garrison Keillor's Lake Wobegon and you'll discover that all the children are above average. Similarly, most stock pickers believe they're above average, too. But the market has a habit of proving them wrong.
Simple mathematics dictate that above-average investors are offset by those who are below average. Extraordinarily good investors, such as Warren Buffett, leave behind them a wake of poor performers.
While it might sound like an easy task to obtain average results from the market, it can be quite challenging when fees and other frictions are added into the mix. But adopting a frugal approach can give you a big leg up on those who are weighed down by fees.
The performance race mainly pits low-cost passive strategies against high-priced money managers. But the money managers – who naturally consider themselves to be above average – haven't fared well, as a group, over the long term on an after-fee basis. (Well, to be fair, their clients get the raw end of the deal.)
A friendly wager nicely illustrates the point. A little over seven years ago, Warren Buffett agreed to a $1-million bet with asset manager Protégé Partners. He wagered that Vanguard's low-fee S&P 500 index fund (VFIAX) would beat a five-hedge-fund portfolio selected by Protégé over the following decade. While the bet is ongoing, Mr. Buffett is winning by a large margin. The index was up 63.5 per cent by the end of 2014, while the hedge fund portfolio trailed far behind with an advance of only about 19.6 per cent.
But Mr. Buffett's enthusiasm for low-cost techniques doesn't stop there. His charitable trusts have been instructed to invest 10 per cent of the money they'll receive from his estate in short-term government bonds. The other 90 per cent will be devoted to a very low-cost S&P 500 index fund like the one offered by Vanguard. It's hard to find a better endorsement for an investment strategy or an index fund manager.
While Mr. Buffett's advice is well suited to U.S. investors with long-term capital to deploy, Canadians should think about making slight adjustments to reflect their individual needs and country of residence.
On the cash side of the equation, a boost should be given to the fixed income side of the portfolio to reflect potential short- and medium-term needs. Here I like to follow money manager Benjamin Graham's advice to put a minimum of 25 per cent of a portfolio into fixed income investments. Conservative investors should lean even more heavily on bonds for their own peace of mind.
In addition, I generally stick to high-interest savings accounts and GICs for short-term money because they usually pay more than federal government bonds with similar maturities.
On the stock side of the equation, I like a simple two exchange-traded-fund (ETF) solution that offers a little more diversification than the S&P 500. It also allows investors to easily adjust their exposure to Canadian stocks.
The first ETF is the Vanguard FTSE All-World ex-Canada Index ETF (VXC), which tracks stock markets outside Canada for an annual fee of 0.27 per cent. The second is the Vanguard FTSE Canada All Cap Index ETF (VCN), which tracks the Canadian stock market for only 0.11 per cent per year. (Both funds will likely reduce their fees over time, based on Vanguard's past behaviour.)
Even if you aren't interested in becoming an index fund investor, you'd be wise to devote some money to an index portfolio for benchmarking purposes. That way you can easily check to see if your own approach to investing adds, or subtracts, value over time. Think of it as an early warning system that can help you change course before your portfolio slips below the surface of Lake Wobegon.