How much does an investment portfolio resemble a tall, non-fat latte with caramel drizzle? According to the twisted logic of financial marketing, they're practically identical. Bank ads imply that since we each demand our coffee just the way we like it, we should also demand the same level of customization when it comes to our investing strategies.
That's oh-so sweet. And oh-so wrong. Coffee and portfolios share only one similarity: their ability to keep you up at night. But one is a matter of taste. And the other is—or, at least, should be—a matter of science.
The science works because people are remarkably similar in their investing goals. We each desire the maximum reward for whatever amount of risk we're prepared to shoulder. Deciding on the appropriate level of risk can be a challenge. But other than that, constructing a smart portfolio is nothing like choosing whether to have cinnamon powder or chocolate sprinkles on your morning pick-me-up.
A better metaphor for investing is brushing your teeth or cutting down a tree. For both of those workaday chores, there's a simple, practical goal and a well-understood path to success. All you have to do is follow it.
Top financial thinkers, including Princeton professor Burton Malkiel and Nobel Prize winner Eugene Fama, offer the same advice. They tell you to build a collection of low-cost index funds that span different regions, and both stocks and bonds. You should adjust the asset mix to reflect your risk tolerance—a 20-something might tilt heavily toward stocks, while a retiree might go in the opposite direction—but there's really no mystery to smart investing.
So why don't more of us actually follow this approach? Maybe it's because we're willing victims. Nothing is quite so seductive as a sales pitch that begins with the notion that we're so special, we need a special strategy to cater to our specialness. Money managers know this and feast on our vanity. They assure us that by paying more in fees, we're getting access to privileged levels of advice.
The problem is, they're not telling the truth. The vast bulk of actively managed mutual funds lag behind their market benchmark over any extended period, according to Standard & Poor's.
Even Harvard and Yale, which have expert teams of academics and Wall Street managers overseeing their multibillion-dollar endowments, have been unable to do much better over time than a simple blend of index funds. In fact, an utterly standard index fund blend of 60% stocks and 40% bonds would have outpaced the returns most Ivy League endowments have achieved over the past decade, according to a recent report by Markov Processes International, an investment research firm.
This result is no aberration. Back in 2008, Warren Buffett entered into a $1-million (U.S.) wager. He bet that a simple S&P 500 index fund would beat a hand-picked collection of top hedge funds over the next decade. He was proven decisively right when the index fund returned an average annual 7.1% against the 2.2% the all-star collection of hedge funds achieved.
Investors who want to follow in Buffett's footsteps should focus on building low-cost indexed portfolios. Among the better options are the target-date funds many employer-run pension plans offer, which provide you with a balanced portfolio of index funds, automatically adjusted to become more conservative as your retirement date nears.
Do-it-yourselfers should also look at the asset-allocation portfolios for individuals that Vanguard Canada recently launched. They allow you to buy a balanced portfolio of index funds with a single click of your mouse. Your only job is to choose your appropriate level of risk: conservative (40% stocks, 60% fixed income), balanced (60% stocks, 40% bonds) or growth-oriented (80% stocks, 20% bonds).
These portfolios won't provide you with much to talk about at dinner parties. They're all about embracing the ordinary. But precisely because of that, they're likely to give you better returns than expensive, customized solutions will. And that should leave you with even more money to spend on designer lattes.