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Why Couch Potato Investing Doesn’t Work

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Why Couch Potato Investing Doesn’t Work …
… For Everyone

Sorry but I couldn’t resist a trick title like that: It’s Friday; It’s overcast; It’s been raining and cold all week so few warblers are bothering to move: I’ve got to have something to smile about. However, today I will argue that for some people Couch Potato investing, also known as index investing, does not work.

What Do I Mean by Couch Potato or Index Investing?

There are several different investing methods that get lumped together under the heading index investing or Couch Potato investing. There is an absolutely fantastic website about this type of investing run by the Canadian Couch Potato at http://canadiancouchpotato.com/ for those of you who would like more information.

What I’m discussing here is a “basic” Couch Potato method of investing:
You invest in 4 types of ultra-low-cost ETFs:

  • A Canadian equity fund that matches an extremely broad and diversified Canadian index
  • A US equity fund that matches an extremely broad and diversified US index
  • A Foreign (non-US, non-Canadian) equity fund that tries to capture a broad swath of the businesses listed on the various international stock exchanges
  • A bond fund (often one with a short term-to-maturity and a mixture of government and corporate high quality bonds)

The percentage invested in each of the 4 ETFs could vary but a common split would be 20% Canadian; 20% American; 20% Foreign; 40% Bonds.

You split your money and invest it at the correct percentage in the 4 different ETFs.

Monthly, quarterly or semi-annually you add new contributions proportionately.

Once a year, you re-balance the portfolio to keep your asset allocations at 20/20/20/40. This could be done by buying more of the class that has dropped with your new contribution or by selling some of your excess units and buying more of your missing units. (E.g. if your allocation has become 30/10/20/40, you would sell some of the 30% ETF and buy more of the 10% ETF.)

You keep doing this for 10-50 years.

You do NOT sell your ETFs randomly just because the stock market is going up or down, only annually if you need to re-balance.

You do NOT invest extra in one of the 4 ETFs just because “it’s on a roll” and you want to make some extra money quickly.

Why Does Couch Potato Investing Work?

This type of index investing works because it takes all of the guess work, timing and emotion out of investing.

It’s based on the theory that over time the value of money invested in the stock markets and bonds will increase so if you invest in them and stay invested at all times, the value of your investments will increase.

Some will argue that you will even earn the most by investing in this way. That gets way too complicated for me to be interested in, but it is generally agreed by everyone that it is a very good way to invest which should result in an increased value of your savings over time.

I keep saying “over time” because at any one MOMENT in time, the value of your investments may NOT be higher. And that’s the problem.

Couch Potato Index Investing Does Not Work for Everyone

The reason couch potato index investing does not work for everyone is that not everyone can stick to it.

Some people cannot accept seeing large decreases in the value of their investments.

Other people cannot accept seeing investments not increase in value over several months or even years.

For example, following a simple Couch Potato portfolio, an investor might put 20% of their money into an International equity ETF. Let’s say they invested $10,000.

During a nasty period of market upheaval, they may see the value reported for their investment in that ETF drop to $7000.

To be a proper Couch Potato investor they must

  • Shrug and ignore it, until
  • during their yearly asset allocation re-balancing time
  • when they must either sell some of their other ETFs to bring the percentage back up to 20% of their portfolio, or
    invest new money in this ETF until it comes back up to 20% of their portfolio.

That’s right: They have to sell their “winner” and buy more of their “loser”; or put more new money into their “loser.”

Because it’s not really a “loser.” It’s just an ETF that has dropped in value. Over time, lots of time, the Couch Potato philosophy says that it will go back up in value and in fact increase in value over the starting value. So by re-balancing, the investor is actually buying more of a “bargain” ETF not a “loser” ETF. And doesn’t everyone like to buy a bargain?

Some people, though, just cannot handle this. At best they will ignore this drop in value of the international ETF and refuse to rebalance their asset allocation annually. At worst they will sell out of their entire position in this international ETF “dog” and put the money into something else.

Either way, they are no longer investing in the Couch Potato Index style.

They are not likely to succeed as a Couch Potato investor because they are ignoring the simple, basic rules that make this style work.

How Can I Decide If I Can Succeed as a Couch Potato Index Investor?

It’s really not possible to be sure how you will react to a dizzying drop in the value of an ETF until it happens. However, you can ask yourself some tough questions to get a glimpse of how you might feel.

The internet is full of great charts.

https://ca.finance.yahoo.com/echarts?s=^GSPTSE
is a link to a Yahoo chart of the value of the S&P TSX Composite Canadian index. If you click on the Max link under the chart, you will see how it has behaved for many years.

https://ca.finance.yahoo.com/echarts?s=SPY#symbol=SPY;range=my
is a link to a Yahoo chart of the value of the SPDR S&P 500 NYSE. If you click on the Max link under the chart, you will see how it has behaved for many years.

It’s not just important to look at those sharp drops.

It’s also important to look at the width between two points at the same height. The width is how many months or years it took for the index to return to the SAME value. Not to increase, just to return to where it was.

Photo of TSX simplified chart

Looking at the Yahoo TSX chart, if you bought units in a matching index fund only in August 2000, you’d have had to patiently wait until about December 2005 just to *break even*. (Dividends will help a bit but not as much as you might think if you buy a “most of the TSX” ETF. Many TSX stocks pay almost nothing in dividends.)

Similarly, if you bought in only at June 2008, you’d have to wait till February 2011 to break even and even then it would go down again only rebounding by September 2013.

If you bought in only during April 2011, you would only have broken even in October 2013.

Image of SPDR 500 simplified chart

The SPDR S&P 500 chart also shows the need for patience. Someone who bought only in September 2007 had to wait till early 2013 just to break even.

NOTE: These charts are not meant to represent the actual ETFs you might buy in your portfolio. They are just meant as quick examples of real market fluctuations.

Are You Brave, Patient and Stalwart Enough to be a Couch Potato?

Intestinal fortitude. That’s what you need to be a good Couch Potato index investor.
You have to be prepared to stomach more than a 30% market drop for one, or more, of your ETFs.

If you truly want to be a Couch Potato, you have to be prepared to lounge back through a 50% market drop and keep waiting, often for years, for your holdings to gradually climb back up to where you bought them at.

That means you have to wait to *break even*, not just to make a profit.

If you sell during a drop, you will almost always lose. And you are not a Couch Potato Index investor any more.

Some people who try to be Couch Potatoes panic when the markets drop. They sell low. They won’t wait years for a rebound. They then curse the markets and stalk off to invest only in GICs and savings accounts.

Regular contributions do make drops easier to weather because you buy some new units when prices are low to help offset the ones you bought when prices were high. It makes it feel like you’re making money more quickly as you wait for the re-bound.

Proper annual rebalancing is also critical and as a bonus it can obscure the cause of your paper losses. (Remember they are not TRUE losses unless and until you sell your ETFs.)

Who Does Couch Potato Index Investing Work For?

It could work for anyone, if they let it.

It certainly will work for someone who is totally dispassionate about finances and fully capable of ignoring even catastrophic market crashes because he/she understands and believes the mathematics behind this investment method.

It works for thousands of people.

It might work for you.

Am I a Couch Potato Index Investor?

No.

I won’t let it work for me: I am extremely risk averse. I know I would not be willing to watch 20% of my invested money (in any one index) drop to half its previous value.

We do use Couch Potato Index Investing within one of our defined contribution pension plans. Frankly we have no other logical choice. It’s doing reasonably well but it sure does hurt to wait out the times the markets are down and the agonizingly long time it takes for the markets to rebound. Fortunately, our bonds fund did extremely well during the last market drop which buffered the loss somewhat.

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Are you a Couch Potato Index investor? Or do you actively trade? Or are you a Fixed Income Only investor? Or do you take a hybrid approach? You’re probably doing reasonably well using any method if you have no debts and are steadily saving money. Please share your opinions and advice with a comment.

Retirement Planning: Testing the TD Retirement Savings Calculator

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As I mentioned in Testing the Canadian Government Retirement Income Calculator, I’ve been curious about how close we are to having enough saved for retirement. Could we step down from high-paying but highly stressful jobs without ruining our retirement? What if we had no choice and the next round of layoffs put us in “early retirement?” The Service Canada calculator said we’d be ok with what we have saved already IF we could earn enough between now and 65 to pay all of our bills during that period. What about other estimates though? The next online program I reviewed and used to test our finances was the TD Retirement Savings Calculator.

Will TD be Phoning Me Trying to Sell Me High Expense Mutual Funds If I Use Their Calculator?

A tiny bit to my surprise, TD doesn’t try to capture any personal information about who is using their calculator. They don’t specifically ask you for your name or telephone number or who you bank with. And it’s been a week since I used the calculator and no strange messages have appeared in my email or voicemail, so I guess I’m safe.

What You’ll Need to Know Before Using the TD Retirement Savings Calculator

  • Your age
  • When you plan to retire
  • How long you expect to live in retirement (this is a value that can be increased on the final screen)
  • What income you require in retirement
    This is a number most of these calculators want you to know. I took a crack at calculating our requirements by back-calculating our spending from our bank accounts as I mentioned in another article.
  • Your current RRSP savings, including your personal RRSP/s, any spousal RRSP/s where you received the money from your spouse, any defined contribution pension plans or group RRSPs from work
  • How much you plan to contribute to your RRSPs both personal and work, or what you expect to have contributed to your spousal by your partner
  • Your current TFSA and non-registered savings for retirement (note you shouldn’t include money your saving for other things like a new car, home upgrades, your children’s education, a vacation etc.)
  • How much you plan to contribute to these other types of retirement savings.
  • What you estimate your annual rate of return will be for your investments including your RRSPs, TFSA, work RRSP or defined contribution plan, and non-registered savings. This is supposed to be just one number for everything.

My Review of the TD Retirement Savings Calculator

Overall I didn’t particularly like this calculator. It doesn’t clearly state its assumptions and it doesn’t clearly define what you should type in to the program.

The program doesn’t state whether the income you require in retirement should be entered in before tax or after tax values. Judging by how little it said we needed to retire, I think you should enter the amount you need before income tax to get a realistic result.

It doesn’t tell you what rate of income tax it is using, if any.

It doesn’t tell you what rate of inflation it is using, if any.

It doesn’t tell you whether it is assuming you will get CPP and OAS and if so at what rate. It doesn’t make it clear whether you should enter income from a defined benefit pension plan in the “If you expect to receive additional income after you retire, please enter it:” field. I suspect you may be supposed to enter all of these types of pensions in this field but it would be nice if it would say so clearly.

It doesn’t seem likely that it is handling taxes properly. For example, it wants you to report how much you  have saved for retirement in non-registered investments and in TFSAs in one total. This isn’t realistic as you could have a stock worth $20 000 that you bought for $10 000. If it’s in the TFSA, when you withdraw the $20 000 you pay no tax. If it’s in a non-registered investment account, when you withdraw it, you have to include the capital gain (currently 50% of $10 000) on your income tax for that year and possibly pay tax on that capital gain, reducing the value of your $20 000 withdrawal.

It doesn’t allow you to select a different rate of return for your RRSP, defined contribution or group RRSP, TFSA, and non-registered investment accounts. You have to come up with some sort of weighted average yourself for what you expect to make across all of your accounts. (I made it easy on myself by choosing the lowest possible percentage. But if you don’t have much saved yet that could be a very depressing, though possibly realistic, way to estimate your retirement!)

It doesn’t allow you to report a different source of other income during different years of retirement, like the Service Canada calculator. This makes it difficult to correctly enter the situation where you  might receive a “bridge benefit” from 55-65 which then ceases when you begin to receive CPP and OAS, or when you might plan to work part time from 65-70 but then stop working entirely.

I also didn’t like the fact that it limited me to living 35 years after retiring at age 65.

Estimating Your Canada Pension Plan Payments and OAS Payments

I discussed how to estimate CPP and OAS payment briefly in the review of the Service Canada Retirement Income calculator.

What Assumptions Does the TD Retirement Savings Calculator Use?

I wish I knew! They don’t clearly list their assumptions.

How to Use the TD Retirement Savings Calculator

  1. Go to: http://retirement-calculator.tdcanadatrust.com/
  2. Click on the Get Started button.

The About You section

The Tell us about yourself: screen

  1. In the appropriate fields, type in your
    • age
    • age at retirement
    • annual income before taxes
      (or select monthly from the drop-down list and type your monthly gross income.)
  2. Click on the Next button.

The Retirement Plan section

  1. In the appropriate fields, type in
    • how many years of retirement you are saving for
      (The maximum is 35.)
    • what income you will want (monthly or annually) in retirement
      I ended up entering our before tax income required not including CPP and OAS.
    • what extra income you expect to receive in retirement such as rental or employment income
  2. Click on the Next button.

The Savings and Investments Section

  1. In the appropriate fields, type in
    • how much you have saved in your RRSP accounts so far
      According to their What should I include? include the amount saved in any RRSPs, spousal RRSPs (where you are the spouse who received the RRSP), LIRAs, defined contribution pension plans, and Group/Work RRSPs.
    • how much you contribute regularly to your RRSPs including your work ones, either monthly or annually
    • how much you have saved for retirement in TFSAs and non-registered investment accounts
    • how much you contribute regularly to these other savings accounts, either monthly or annually
  2. Click on the Next button.

The Rate of Return Section

  1. In the % estimated annual return field, type in how much you expect to earn on your investments annually.
    The lowest you can select is 1%. The highest is 10%.
  2. Click on the Results button.

The Results Section
The program will tell you what your retirement savings goal is, based on your expected retirement income needs, current savings, future contributions to savings, and estimated longevity in retirement.

It will also tell you what your projected total savings will be.

If applicable, it will tell you how much you still need to save.

Don’t just close your session yet, though! You can now adjust some values more than you were permitted on the original screens.

There are four expandable lists:

  • How much I save
  • How much I spend
  • How long I’m in retirement
  • How quickly my savings grow

These allow you to change some of the information you entered without going back through all of the screens.

What Did TD Say About Our Joint Retirement Income?

Well it depends. If we put in the income we needed in retirement (after OAS and CPP) and we assumed it was an after-tax number, it said we are over-funded for retirement, just using our RRSP and work DC pension savings.

If, however, we put in a larger income needed in retirement in case the program expects a before-tax number, it said we would need to use our TFSAs and some of our non-registered savings to be funded for retirement.

So it agreed with the Service Canada calculator that said if we stopped saving for retirement now, and made sure we didn’t incur any debts between now and retirement, we’d be ok in retirement.

But do I trust it?

No. They don’t state many very important assumptions. I want another opinion!

I’d better test the same numbers with some other calculators. And although it’s nice of them to offer, I don’t think I’ll call TD to discuss how to reach our retirement savings goal.
In the meantime, we’ll keep saving.

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Have you ever checked whether you’re on track for retirement? Or do you only need to look at your credit card statements to know that you’re not? Please share your views with a comment.