Thursday, July 12, 2007

You're going to need a bigger boat

Alternate title: why it's hard to diversify

Despite the Oracle of Omaha's sermons on the dangers of overdiversifying, I must admit I believe in the principle of hedging your bets. Sure, if you're as smart as Buffett, you can set your lot in with your top 10-or-so stock holdings, secure in the knowledge that they're likely to outperform.

But since the rest of us can't really expect to "beat the market" on a consistent basis, spreading your money around between assets that rise and fall out of sync with one another to try to ensure that you end up on top overall in the end is a sound policy. This works great if you have substantial assets, but a lot of DIY investors -- especially when they're starting out -- don't have enough capital to easily diversify, and fees quickly eat in to returns.

If you were an investor starting out who wanted to be able to sleep at night but retire wealthy, I'd probably recommend the Couch Potato strategy. It goes by many names, but in a nutshell, it entails buying a basket of low-fee index funds in different sectors (a classic choice for a Canadian might be 25% in a Canadian stock ETF, 25% US, 25% international and 25% bonds) to spread the risk around. Then, once or maybe twice a year, you sell off gains in the winners and pad up the losers with the proceeds. The idea is to maintain that 25/25/25/25 ratio, only the total value of the portfolio (as opposed to the ratio) goes up year after year.

The problem? In Canada, in my experience, doing that can rack up a lot of trading fees.

Let's say you started out with $8000 to invest. (For the record, I think this is actually a lot more than most people have starting out, but I'm trying not to skew the numbers too far in my favour here) You put $2000 into an ETF in each of the above sectors. At the end of the year, let's assume that the Canadian portion has risen to $2300, the US portion dropped to $1950, the international portion rose to $2100 and the bonds rose to $2050. Your portfolio is now valued at $8400. Well done! So 25% of that would be $2100. This is your new goal for each sector's value at the start of the next year.

Under the classic couch potato rules, you should then sell off your gains in your big winners ($200 from Canada) and pad up your laggards (USA and to a lesser extent, bonds) So you buy $150 more worth of the US ETF, $50 more worth of the bonds ETF, and leave the international portion the same.

The problem? With some Canadian "discount" brokers, you may pay as much as $30 per trade. In this scenario, you pay $30 to sell off part of Canada, $30 to pad up USA and another $30 to pad up bonds. Total cost = $90. Which represents 22.5% of the gains you made that year. You won't get very far giving away 22% of your gains every year to trading fees. And these don't even include other things, like the fee a broker may charge you to manage the account if its an RRSP (as high as $75 in some cases)

I realize I've skewed the numbers a little bit to prove a point (the simple truth is that in today's day and age, nobody should be paying $30 per trade anymore because you just don't have to) but the point is still valid: it's hard to do the right thing and diversify when you're working with small amounts of investment capital to start with. Many people recommend using low-fee index funds like TD's e-funds for just that reason, and I must admit, it's an option I wished I'd considered for myself starting out.

I realize it's slow and plodding, but if you forgo the e-funds route, maybe a wise thing to do starting out is either keep it all in a high-interest savings account until you reach a certain plateau ($10,000 maybe, that you can spread between only three sectors) or, riskier still, put it all into one relatively secure holding (a balanced mutual fund, or a Canadian bank stock, maybe) until you reach the point where you can diversify yourself without holding yourself back.

I know it's risky to put all your eggs in one basket for a time, but it certainly seems better than the alternative outlined above. Most investors starting out have time, if nothing else, on their sides, so it might not be the end of the world if they take a huge hit. Just get back on the horse, and stick with the long-term plan.


Mr. Cheap said...

One way to avoid these fees is to rebalance your funds when you add money (whenever you want to buy more, just buy the losers to bring them up to the same level as the winners).

I think a lot of people worry about reblancing too early. As you say, time is on your side when you start out, so I'd just put it all into one of the 4 funds that sounds good. Next time you're buying, pick another. Learn as you go, and once you've saved enough that trading fees are less significant, then start maintaining the 25/25/25/25 balance.

FourPillars said...

I think that rebalancing is secondary to doing the low cost investing in the first place, so if your portfolio is small - then don't rebalance until it's larger. It's not going to make much difference.