Warren Buffett thinks novice investors should start with index investing and for good reason. It's a great option for all sorts of investors when done right with a balanced selection of low-fee funds.
But it's not without risk. New and old investors alike have to be prepared for ups and downs along the way without becoming overly alarmed.
Conservative investors need to be aware that bond-heavy portfolios can lurch around alarmingly from time to time. On the other hand, the promise of high returns from stocks might prove to be nothing more than a mirage, which the last decade has proven all too well.
Squeamish investors should dial up their bond holdings to sleep better at night but they'll likely sacrifice returns in doing so. Alternately, portfolios crammed full of stocks might fare better but the ride will probably be a wild one. Pick your poison.
Before you do, it helps to get an idea of the range of possibilities you're faced with. I like to start by examining how seven different portfolios composed of varying amounts of bonds and stocks have fared in the past.
On the bond side I decided to use an equal blend of short-term and long-term Canadian bond indexes using Libra Investment Management's database which stretches back to 1970. That way the results include the great bull and bear markets for bonds, and stocks, in the 1970s and 1980s.
On the stocks side I went for an equal blend of S&P/TSX composite for Canadian stocks, S&P 500 for U.S. stocks, and MSCI EAFE for international stocks. It's a simple and popular mix for many indexers.
The returns generated by portfolios of various blends are shown in the accompanying table, which assumes annual rebalancing. The best and worst yearly returns are provided along with the average return for each portfolio from 1970 to 2012.
It's important to note these figures are reported in Canadian dollar terms and are adjusted for Canadian inflation levels, which compensates for the declining purchasing power of the dollar. Without such an adjustment one could be easily fooled by the numbers in periods when inflation runs rampant.
As you can see, the bond-heavy portfolios might not be as placid as one might expect. The best year for the all-bond portfolio saw a sizable 20 per cent gain. On the other hand, the worst year resulted in a decline of 10 per cent.
Bond indexers need to know their bond funds can have good and bad years once inflation is taken into account. Even more so now that bond yields are extremely low. Should inflation take hold, we might be facing something of a repeat of the 1970s when bonds fared miserably.
On the whole, the results for all of the portfolios were pretty good but many investors aren't likely to achieve them. They'll be sorely disappointed for several reasons. Two big factors are taxes and fund fees, which aren't included in the returns. If you pay 2 per cent in fees and give, perhaps, a third of your gains to the taxman then you won't have much left over in the way of real gains. You'll have taken on all the risk only to see your "partners" take most of the gains. Cut them out with sensible tax planning and low-fee exchange traded funds.
Even low-fee tax-optimized balanced portfolios face difficulties today because the yield on Canadian bonds is very low. To get a real return of 5 per cent on an equally mixed stock and bond portfolio you'd need to see stocks gain more than 9 per cent a year, which seems unlikely at this point. Because most people wind up in reasonably balanced portfolios, it's more critical than ever to avoid high fees. Unless, of course, they're keen on the Freedom 75 plan.