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Why You Should Become a DIY Investor

You’re a smart, self-reliant person. You pride yourself on being prudent with your money. So why are you paying someone else to manage your investments?

Feb 1, 2012

by Max Fawcett

Click here to listen to a podcast exploring the upsides of DIY Investing

Your financial advisor is probably a nice person. Really nice, even – the kind who sends you a culturally appropriate card during the holidays. But if you’ve been with him long enough, the odds are pretty good that despite his expertise and assistance, your portfolio hasn’t done very well lately. Worse still, you’ve been paying him a fee, year in and year out, for his help. It might be time to give him the boot.

After all, no person of sound mind would pay a mechanic to leave his car in worse shape than he found it or a tailor to taper a dress shirt so aggressively that he couldn’t put it on without first having to lose 20 pounds. But those same people routinely shell out thousands of dollars every year to someone, be it an advisor or a mutual fund manager, just to have their portfolio underperform the market average.

Firing your financial advisor right now might sound like the worst piece of advice you’ve received since your cousin told you to buy shares in Bre-X. With the equity markets displaying the volatility of a Hollywood starlet trying to kick her Percocet habit, you might think the steadying hand of an investment advisor is more important than ever. You’d be wrong.

The false promise (and premise) of active management is best demonstrated by looking at the performance of actively managed mutual funds, the great pools of money managed by the supposed wizards of Wall and Bay Streets. According to a recent study by Morningstar Canada, actively managed funds haven’t outperformed their benchmark index and, in many cases, have dramatically underperformed them. Over the last 15 years, for example, only 31 per cent of actively managed funds that focused on large cap companies have outperformed the S&P 500. And while actively managed funds have done slightly better in the recent bear market, there are still 42 per cent of actively managed funds that have underperformed their benchmark index over that period. If this is the kind of performance produced by the financial services industry’s best and brightest, what are the odds that your comparatively inexperienced financial advisor (who has probably suggested these very same mutual funds to you on more than one occasion) can do any better?

You probably have a work colleague or a friend or a cousin whose advisor has knocked it out of the park over the last year or two or even five. If they can do it, you’re saying to yourself, why can’t somebody else? Well, you’re half right. Somebody else can do it and somebody else will. The problem, says Jason Zweig, an investing columnist for the Wall Street Journal, is that you’ll never be able to know who that is in advance. “Your chances of selecting the top-performing funds of the future on the basis of their returns in the past are about as high as the odds that Bigfoot and the Abominable Snowman will both show up in pink ballet slippers at your next cocktail party.”

What to do, then? Read on and find out.

Look Before You Leap

If you’ve never considered managing your own investments, the idea of doing it yourself may seem as safe as walking a high wire without a net. But there’s an easy solution: don’t remove the net until you’ve done a few practice runs across the wire. That’s more or less what Duncan Hood, the former editor of MoneySense magazine and current editor of Canadian Business, did when he decided to strike out on his own a few years ago. He started off buying “wrap funds” – essentially a mutual fund of mutual funds – from the bank he had his accounts with before he realized the costs they charged were eating into his returns. Hood eventually moved into index funds but says it was more a progression than a leap of faith. “I don’t think I would have been ready for index funds earlier. I think I had to go through that progression of starting off in a wrap fund, realizing at some point that the fees that I was paying were quite high and then realizing that I could lower them by doing some of the work myself. I think a lot of Canadians aren’t ready for that step until they’ve already gone through the other steps. It’s a progression.”

Cost it Out

Mutual funds have been around since before the Great Depression, but it wasn’t until the 1980s and 1990s that they went mainstream. It was an age in which a poorly trained golden retriever could have delivered double-digit returns – a bull market to end all bull markets, fueled by millions of baby boomers who were all discovering the virtues of the stock market at the very same moment. In that climate, quibbling about costs and fees probably seemed downright petty, like haggling over the price of an after-dinner digestif at a five-star restaurant.

In 2012, of course, that climate has changed. Returns that would once have been downright embarrassing – single digits, God forbid – are now seen as enviable. Meanwhile, the two or three per cent in fees that weren’t a big problem when returns were 15 to 20 per cent are suddenly a major pain in the portfolio. That’s why index funds and ETFs that seek to mimic those indexes have become so popular.

Take the comparative performance of Mackenzie Financial Corporation, a fund family that has more than $100 billion in assets under management, and the iShares S&P/TSX 60 Index Fund ETF. Mackenzie offers investors a wide variety of funds with different areas of interest and styles of management, all of which come with snappy names (Cundill Funds, Ivy Funds, Maxxum Funds, Sentinel Funds and so forth) and glossy prospectuses describing what they intend to deliver for investors. They also charge management fees that often exceed two per cent.

That compares poorly with the 0.17 per cent management expense ratio (MER) of the iShares product. When it comes to the impact of this fee spread on returns, the proof is in the prospectus. As of October 31, 2011, only one of the 19 Mackenzie funds with a five-year performance record – the Mackenzie Saxon Dividend Income Fund Investor Series – outperformed the iShares ETF. And of the 15 Mackenzie funds with a 10-year performance record, only two managed to beat the 8.01 per cent return posted by the iShares ETF.

Build a Support Group

It’s one thing to know how to build your own portfolio. It’s quite another to actually do it, particularly in a time of extreme volatility.

Professional money managers may not be particularly good at outperforming the markets, but they’re excellent resources in times of crisis, often steering clients away from making emotionally driven decisions – “sell everything,” usually – and back towards their long-term strategy. That, in itself, is nearly worth paying for, given that a badly timed sell order (or an equally ill-advised buy) can do terrible damage to a portfolio. In fact, the financial services industry might be better served marketing its people as money therapists rather than money managers.

But here, too, investors can learn to do this on their own. They can start with some basic reading on investing and the fundamentals that underpin its most successful practitioners. During a time of turmoil in the markets, when the talking heads are screaming about the coming depression or why the Dow Jones is headed to 5,000, it never hurts to have a handbook of wisdom and advice you can turn to.

There are also a number of investment-oriented online communities on the Internet, many of which are populated by experienced investors who are more than happy to give some advice free of charge. These websites also have the virtue – one you don’t get from a paid financial advisor – of effectively testing every claim or call somebody makes against the wisdom of the crowd.

Keep it Simple

The financial services community thrives on offering new products for investors, and in recent years it has pioneered the widespread use of derivatives, options and other complicated instruments. But the truth of the matter is that you don’t really need to know how those work or how to use them. Instead, keep things simple.

That’s the rationale behind the so-called “Couch Potato Portfolio” that was invented by financial journalist Scott Burns in 1982 and popularized in Canada by MoneySense magazine two decades later. Forget complicated derivatives, options trading or even the more old-fashioned practice of stock picking. Instead, figure out your risk tolerance and allocate your money to ETFs that track the broadest available markets.

For example, if you want to have 60 per cent of your money in equities and 40 per cent in bonds, you would put 20 per cent of your cash into a Canadian equity ETF, 40 per cent into an international equity ETF, and 40 per cent into a Canadian bond ETF. That’s it – just three investments, no matter how large your nest egg might be. You can tweak the percentage that goes into bonds and stocks, of course, and add a bit of colour to this basic template by allocating 10 per cent to an ETF that tracks REITs, real-return bonds, preferred shares, gold or a specific emerging market if you so prefer. But in the end, as counterintuitive as it might sound, it’s best to keep things simple.

Take a Walk

In his seminal 1973 book called A Random Walk Down Wall Street, Burton Malkiel made the unpopular case – at least, unpopular on Wall Street – that stockbrokers weren’t actually able to outperform the market indices. His book eventually gave birth to the so-called Random Walk Theory, which postulates that the future path of a given stock’s price cannot be predicted effectively or reliably by charts, momentum or any other form of pattern recognition.

The book also gave rise to the index fund, a financial instrument that sought to track the performance of an index rather than trying to beat it. “What we need,” Malkiel wrote, “is a no-load, minimum-management-fee mutual fund that simply buys the hundreds of stocks making up the broad stock market averages and does no trading from security to security in an attempt to catch the winners.”

It wasn’t long after that the first such index fund was created, and on December 31, 1975, the Vanguard 500 Index Fund was made available to investors. Interest in the product, which tracked the Standard & Poor’s 500 Index, was slow to build, and the fund started with only$11 million in assets. But as its merits became self-evident and institutional investors started to buy in, it mushroomed in size. By March 31, 2011, it controlled over $54 billion in assets.

Click here to listen to a podcast exploring the upsides of DIY Investing

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