Friday, 30 May 2014

A Lifelong Portfolio and Investing Plan for the Reluctant Investor - Aims and Plausible but Inadequate Options

"Everything should be made as simple as possible, but not simpler." Albert Einstein
Some people enjoy investing, but many do not, looking upon it as a necessary evil that is daunting for its complexity and potential danger. Even the slimmed down list of essential topics for the self-directed investor we presented in our last post may be too much for many, whether due to time or interest. Are those people to be forced to avoid self-directed investing altogether?

Today we take up Einstein's challenge for the Canadian self-directed reluctant investor, the person who just wants to be told told what to do in the least amount of time in the least technical manner possible but who insists on something that is effective. First, let's be more specific in defining what the portfolio should do.

Objectives of the Portfolio
We set the following demanding objectives for our portfolio. Our solution is necessarily a compromise to some degree as there are trade-offs amongst several objectives.
  • Suitable for all ages and phases of life from savings through to withdrawal in retirement - the same securities, which will be Exchange Traded Funds (ETFs), in the same proportions, forever; the portfolio never needs to change
  • Suitable for any type of account - RESP, RRSP (and all the other registered retirement account variations like RRIF, LIRA, LIF), TFSA or even taxable
  • Suitable for any investment time horizon - the portfolio should be good enough to do an ok job whether it will be cashed in a tomorrow or in 40 years. Thus, we try to remove the planning headache of figuring out when we will need the money and trying to adapt the portfolio's holdings to match. Can we really be sure anyway when we will want or need the money? Things change and life is full of surprises. We want a portfolio that copes well with uncertainty. 
  • As automatic as possible in every way, from contributions, to investment, to on-going management like re-investment of interest or dividends received, to withdrawal
  • As low cost as possible - the lower the fees incurred, the more stays in the investor's pocket
  • As tax effective and simple as possible - investments should be put in tax-advantaged accounts like TFSA and RRSP where no tax reporting is required and, when those are filled to maximum contribution limits, in a regular taxable account. Should tax reporting be required, we want that process to be as straightforward as possible too. Einstein had it right on this point too, when he said, "The hardest thing in the world to understand is the income tax." This is one area where we could not eliminate complexity entirely. The problem is with taxable accounts and the calculation of capital gains, where the investor must keep track of Adjusted Cost Base. 
  • Incorporating diversification to limit volatility at all times and to benefit from the longer term re-balancing boost to returns
  • Avoid the potential complexities of dealing with foreign exchange, while gaining the return and diversification benefit of foreign investments. The foreign investment objective is the biggest compromise of our Reluctant Investor Portfolio, as our proposal is Canadian investments only. 
  • Minimize mental stress and danger of panic reaction of selling at the wrong time (e.g. late 2008 after the stock market plunge in the financial crisis) by limiting volatility. At the same time, the portfolio is very orthodox mainstream, so that the investor can feel comforted doing what the average of everyone does, reducing the risk of regret. 
Testing the Portfolio through Historical Performance - To see what kind of performance the Reluctant Investor Portfolio would have provided, we will turn to the Stingy Investor Asset Mixer tool.

Alternatives, with the Trade-offs that led to rejection
Before we reveal the portfolio and investing plan that we believe best fits the objectives, let's look at some options that don't quite work in our view.

1) iShares Balanced Income CorePortfolio™ Fund (TSX symbol: CBD) - That's right, a single fund, only one thing ever to buy or sell. This ETF is a serious contender that might still appeal to some.

  • Maximum convenience and simplicity: a single ETF that avoids any need for the investor to do rebalancing, it is all done automatically within the ETF by the iShares managers; this ETF is part of iShares' free DRIP, PACC and SWP plans meaning you can set up instructions for regular contributions or withdrawals; no worries of questions about which ETF goes into which account; only one ETF for which to keep track of Adjusted Cost Base for eventual capital gains reporting if held in a taxable account
  • Well diversified with many types of stock and bond holdings, including foreign holdings; in this aspect it is better than the Reluctant Investor portfolio
  • Annual fees at 0.72% is starting to be a bit high, eating into net returns
  • Volatility is higher despite the variety of holdings - in its short history from 2007 startup, it declined about 25% by early March 2009. Though it has recovered strongly since, that might be too un-nerving for some to stick with it. Plus the effect of withdrawals at that point when in retirement mode, would seriously harm the portfolio.
2) All Bonds, whether a broad Total Market mix or Short-term Bonds

  • Convenience and simplicity, due again to holding only a single fund
  • A bit less volatility - there were fewer down years than for our winning choice according to Stingy Investor, though the difference is slim and not always favorable when it included annual retirement withdrawals of 4%
  • Lower returns and much less total accumulation during savings mode per more historical calculations and very slim returns in retirement withdrawal mode. The clincher for us looking forward is that we know bond returns since 1980 have been greatly boosted by falling interest rates. That trend has stopped now at the bottom so betting all on bonds cannot produce the same juicy returns. That's an important principle of our winning portfolio - it hedges the uncertainty of whether stocks or bonds will do better.
  • No tax efficiency if held in a taxable account - interest income is taxed at the highest marginal rate
3) GICs only

  • Simplicity - everyone knows and understands how they work
  • Stability - their price never varies (though there is an implicit but not visible change in value when interest rates change) and the price paid back is known in advance
  • Convenience - Minimum purchase amounts start at $500, but how is an investor to manage purchases on a regular basis. Avoiding having a multiplicity of small GICs that will require constant effort to track and reinvest as they mature, as well as time to look up the best rate, which changes constantly from the different financial institutions. Automatic reinvestment with the same financial institution won't get the best rate. Getting the best rate also means tieing up money in non-cashable GICs, which makes it impossible to get all, or even most, of your money fast if you suddenly want to make a big purchase, especially if one implements the oft-suggested 5-year ladder of GICs.
  • Returns are lower over the long term, as this historical table from London Life of GICs against TSX stocks and other investments shows
  • No tax efficiency if held in a taxable account - interest income is taxed at the highest marginal rate
Nest week, we will reveal what we believe is the winning formula for Einstein's challenge - the portfolio and the investing plan to go with it.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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