Over the past couple of weeks, I wrote about how beginners can start a long-term portfolio as a cornerstone to building wealth.
Investing with Indexes
Both articles were very similar in that I recommended a globally indexed portfolio. There are a number of ways to build an indexed portfolio, but these articles got into the details of buying index mutual funds through a bank and buying lower-cost ETFs through a discount broker.
So if the reader wanted to go with a 60/40 portfolio with $30k, it would look something like this:
- TD Canadian Index Fund-e: 20% or $6,000
- TD US Index Fund-e: 20% or $6,000
- TD International Index Fund-e: 20% or $6,000
- TD Canadian Bond Index Fund-e: 40% or $12,000
If the reader wanted to get a little more aggressive with a 75/25 portfolio, it would look something like this:
- TD Canadian Index Fund-e: 25% or $7,500
- TD US Index Fund-e: 25% or $7,500
- TD International Index Fund-e: 25% or $7,500
- TD Canadian Bond Index Fund-e: 25% or $7,500
…If the young investor is comfortable with risk and willing to go 100% equities, I would build something like this:
- Canadian Equity: iShares Core S&P/TSX Capped Composite Index ETF (XIC): 25%
- US/International Equity: iShares Core MSCI All Country World ex Canada Index ETF (XAW): 75%
With new savings every year, you would rebalance back to the percentages indicated above.
A two ETF solution is pretty simple, but what if it could get even simpler? Vanguard has introduced all-in-one ETFs that give Canadian investors global diversification for a relatively low management expense ratio. There are three options:
- VCNS – 40% equity/ 60% fixed income
- VBAL – 60% equity/ 40% fixed income
- VGRO – 80% equity / 20% fixed income
Why Index Funds?
Why do I often recommend indexed portfolios to investors, especially those that are just starting out?
- It’s Easy! The goal of investing is to stay invested for the long-term to take advantage of the power of compounding over the decades. An indexed portfolio, especially if you go with a Vanguard all-in-one ETF, is easy to set up and maintain, all while helping you stick with the strategy.
- It’s Cheap! In addition to easy, choosing to index is much cheaper than going with active mutual funds that banks/advisors often recommend. When I say cheaper, I mean lower annual fees (MER). Even though the MER is not paid out of pocket, it’s taken from portfolio returns which can make a HUGE difference over the long-term. Dropping your portfolio MER by only 1% results in a 30% larger portfolio over 30 years. Discount brokers are making it even cheaper to trade ETFs, where some even offer FREE commission on ETF trades.
- It Outperforms! Research has been shown that indexed mutual funds/ETFs outperform active funds over the long-term. The fact of the matter is that active funds have a huge disadvantage due to higher fees. Of course, there will be exceptions, like Warren Buffet and Peter Lynch. Although even Mr. Buffett suggests that 99% of investors should index their portfolio.
Taking on More Risk
This is all well and good, but what if the investor wants to take on some risk? Should a long-term portfolio have high-risk investments? What about taking on high-beta (high volatility) stocks?
In a previous article, I wrote a little bit about how the market defines risk:
Let’s start off by talking a little more about risk. The market defines risk as volatility in the market, in other words, how much returns go up and down every year. Some years can be up (like since 2009), or you could get some years that can be down (like in 2008). However, that is short-term thinking. Over the long-term, or any 20 year period, the stock market has gone up.
So in knowing that the market goes up over the long-term, is there any real risk over the short term? With the long-term in mind, corrections and bear markets are now an opportunity to buy assets at a lower price. Seeing an opportunity when everyone else is running for the hills (ie. selling) can be a real paradigm shift for some, even for some of the most seasoned investors.
Having said that, there is a risk to investors with shorter timelines to retirement where they will need to start spending from their investments. In this case, volatility matters because withdrawing large amounts during a bear market can be harmful to a portfolio. As investors get closer to retirement, asset allocation matters.
To mitigate “risk”, it is often recommended to increase your “fixed income/bonds” allocation in your portfolio (asset allocation matters). For investors who can stomach volatility, to maximize risk (and also long-term return), an investor could go 100% equities and even put a higher weighting on small caps.
In saying that, should an investor trade individual high-beta stocks like Facebook, Netflix or even weed stocks? (as an aside, most of the big tech names are covered under the S&P500 index)
As always, the answer is that it depends. In my opinion, in order for an investor to trade high-beta individual stocks, they need to be interested in watching and researching stocks on a regular basis. Watching and researching is not required with an indexed portfolio – which is really one of the major benefits of indexing. In addition, trading stocks requires the stomach to endure extreme volatility that indexes rarely see (besides extreme cases like 2008).
In my case, I have an interest in the stock market, individual companies, and I enjoy trading. To get “trading” out of my system, I have allocated about 5% of my portfolio for higher-risk positions like high-beta tech stocks, and the occasional cannabis company.
This is the “core and explore” strategy where 95% of my portfolio is composed of steady dividend companies and indexes, then 5% is allocated as my fun trading account.
Indexing can be boring, but boring is really another benefit because it prevents the investor from getting in the way by buying and selling based on emotion. Simply keep buying on a regular basis and you’ll be wealthier in the long-term.
However, for those investors who are interested in trading stocks, I would recommend setting up your core portfolio first, then take a small percentage of your portfolio to dabble in high-beta stocks (core and explore). At least that’s what I do.