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.

ETFs 2.0

I was a little later than usual in getting my hands on the latest issue of MoneySense magazine this month, and I'm not sure what to think about an article on ETFs I read in it. (I can't find it available online yet, but it's on page 10 of the May 2007 issue, written by Duncan Hood.)

BetaPro Management -- a division of Jovian Capital Corp. -- has come out with two ETFs that essentially allow investors to bet on what direction the TSX is headed in. The Horizons BetaPro S&P/TSX 60 Bear Plus fund (HXD) is designed to provide bear market returns by betting that the market is headed down. The company also has a similar product designed to supercharge returns in a general bull market.

Essentially, this makes it easier for retail investors to short-sell the stock market.

Think the blue-chip-laden TSX 60 is headed down? Buy the HXD ETF. Every 1% loss in the index translates into a 2% gain in this ETF's value. But beware -- if you guess wrong and the index goes up, the value of the ETF will decrease, again, by twice as much. Theoretically, you could see your investment go all the way down to zero. And don't forget, the MER is above 1% -- a number that strikes me as being suspiciously high for an ETF.

My initial reaction was shock. I mean, this seems like a fairly speculative vehicle. But the more I think about it, I can perhaps acknowledge a limited role for this product in a conservative portfolio -- albeit a very small role.

Say you set aside a small percentage of your portfolio -- something under 10%, and put it into a product like this. With the TSX having been on such a good run for so long, we all know a pullback is coming at some point. So perhaps some exposure to this potential for gains in a down market could provide some sort of protection.

But sensible investors would limit this product to a small percentage of their overall portfolio. Anything more than that is just asking for trouble.

I'm not particularly inclined to jump in myself at this point, but I do think it's interesting for what it says about the evolution of the ETF: A vehicle that was originally designed to provide market-indexing at rock-bottom prices now includes variations of itself that actually do neither.

Another case for indexing

Another voice joining the chorus in favour of indexed portfolios, as opposed to constantly trying to beat the market.

This time, the voice belongs to Henry Blodget -- former Merrill Lynch analyst who made a name for himself as a tech guru during the boom, but was chopped down as a pariah in the bloodbath that followed.

In his recent article on Slate, Blodget urges investors to stop trying to pick individual stocks that will beat the market, because the vast, vast majority of people will fail.

The reasons he offers are nothing new -- it's very hard for a layman to outsmart the collective wisdom of Mr. Market, and even if (s)he does, once trading costs are factored in any small gains are wiped out.

Yet, we all try, don't we? Blodget's piece offers a reason:

The problem for investors is that even though stock-picking usually hurts returns, it's extremely interesting and fun.

Ain't that the truth.

Just some food for thought if you're wondering where to stash that cash you've squirreled away this RRSP season. If you're smarter than the average bear, best of luck to you. But the vast majority of us are better off indexing.

I hate fees -- and you should too

Yet another worthwhile issue of MoneySense magazine plunked into my mailbox this week. I highly recommend getting yourself a subscription -- it's easily the best $20 I ever spent for my personal finance education.

A highlight for me was Duncan Hood's column on page 16, entitled Do fees really matter?

It's not available online yet, I don't think, and while I highly recommend buying yourself a copy, I'm going to excerpt a particularly enlightening passage here because it provides mathematical ammunition for why investing fees are the surest, quickest way of eating into your investment returns.

If you invest $100,000 in a standard portfolio of stocks and bonds for 25 years, history suggests you might get an average return of 7%. At that rate, your money would grow to more than $540,000.

But taxes takes the first bite out of that.. If you keep you portfolio outside an RRSP and you earn $75,000 a year or more, you will end up paying taxes on your investment returns of at least 20%, reducing your rate of return to 5.5% a year and leaving you with a portfolio worth just under $400,000.

Once we factor in inflation, which has been running at about 2.5% a year, your return drops to 3%, leaving you with a portfolio worth $200,000 in today's dollars.

The average Canadian mutual fund charges 2.5% per year in fees. That won't take a full 2.5% off yoru returns as fees are deducted before taxes and inflation, but it will do some serious damage, Fees reduce your return to 1%, leaving a portfolio worth $130,000 in today's dollars

At the end of our experiment, the sample portfolio has been knocked down from 7% growth a year to 1% a year. That bleeds the hypothetical $540,000 portfolio into an actual $130,000 one.

$30,000 profit to show for a quarter-century of diligent, diversified investing?

Fees matter. Anything you can do to reduce the amount that is trickled out of your portfolio every year, do it. It all adds up.

If you're paying a financial advisor 2% of your money each and every year to buy you a Canadian index fund, stop. And say it with me: ETFs! ETFs ETFs!