Last Thursday, Dan Bortolotti from the Canadian Couch Potato wrote one of my favorite articles that I’ve read in a while: Why Your Problem Is Not Your Funds.
The theme of this article fits right into the points I made when questioning why investors feel like they have to beat the market, but he makes many of the arguments much better than I did. I would highly encourage anyone with any interest in investing to check the article out themselves, but today I’d like to talk about a number of the reasons why I think the message it delivers is so important.
The Canadian Couch Potato is a site dedicated to an index investing approach. An index approach to investing is one that attempts to capture market returns in the most efficient, cost-effective way possible. It is a strategy born out of the huge amounts of data showing that even professional investors fail again and again to beat the market, and that there are very simple indexing approaches that allow you to achieve superior returns.
But even within the broad concept of index investing, there are many different strategies. There are always people looking for an edge, and this leads to a never-ending parade of “new and improved” indexing approaches, each of which promises to be better than the one that came before it.
Dan’s article is in response to people asking him for his thoughts on one particular new indexing strategy. His viewpoint, and it’s one I 100% agree with, is that the real problem investors face is not finding the absolute optimal strategy. It’s not that they could have achieved 1% better returns if they had only used a different approach for the last 10 years, 30 years or whatever. It’s that they can’t even pick an approach they like and stick with it, and this lack of discipline is what truly keeps them from reaching their goals.
Tell me again, why are you trying to beat the market?
My absolute favorite part of Dan’s response comes right in the middle of the post. I’m just going to quote it here because it’s so damn good:
Has there ever been an investor who fell short of his financial goals because he earned only the returns of a cap-weighted portfolio? “I did everything right,” we’d hear him lament. “I paid down my debt, lived frugally, and saved regularly. I built a diversified, low-cost, tax-efficient portfolio of index funds appropriate to my time horizon and risk profile. When stocks plunged I kept my head and stayed invested—I even rebalanced to get back to my targets. I ignored all forecasters and swore off market timing. Now look what happened: my cap-weighted funds underperformed the hypothetical backtested performance of several alternative strategies. Now I can’t have the retirement I hoped for.”
When I read that passage above, the absurdity of it really struck me as comical. But the point here could not possibly be more profound or more important for investors to understand. The true secret to investment success is not picking the perfect strategy. It’s understanding your personal goals and making a plan to reach them. It’s picking a “good enough” investment strategy and having the discipline to stick with it through the ups and downs. It’s being able to ignore the noise around you and focus on yourself.
There are so many simple things we can directly and easily control that will put us on the right path towards reaching our goals. Constantly striving to get better than market returns is simply not one of them, and if you aren’t already following all of the principles laid out above, then trying to beat the market should really be the least of your concerns.
Will you stick with your plan?
My other favorite part of Dan’s response came in one of the comments. Again, I’m simply going to quote it directly because it’s so good:
I can’t prove this, but in my experience there are two broad categories of index investors. The first recognizes that broad diversification, low cost and discipline are what matter most, and that’s enough for them. The second recognizes the value of these three things but is constantly searching for something better. There might be something better, I don’t know. But this group will never be content with their current strategy, and it’s the constant search that leads them them to tinker.
If someone came to me and said they’ve been using some specific alternative indexing strategy in a disciplined way for five years—especially a strategy that lagged the market for some period—I would encourage them to keep it up. But I have never met one. Usually what I see is people who are dipping a toe into this and that, trying to figure out the optimal strategy, putting a lot of value on recent performance and hypothetical backtests, poring over every research paper that promises some improvement on traditional indexes, etc. I do feel these investors are far more prone to stray from what’s important.
Again, it’s the ability to focus on what’s important that separates successful investors unsuccessful ones. Getting the big things right (diversification, low costs) and sticking with them is much more important than trying to predict the little things that may give you a slight edge. And in trying to do the latter, you’re much more likely to continually switch strategies, which in turn is much more likely to harm your long-term success than to help it.
This is an article I will point to for years to come because the message is so important and so well articulated. There are certain things that truly matter for an investor to be successful and other things that don’t. Being able to distinguish between the two and consistently doing the things that matter will make all the difference in allowing you to reach your financial goals.
Other articles I think you’ll like
Planting Our Pennies: Following up on their great article from a couple of weeks ago, the Pops look at the numbers comparing a 20% down payment to a 3.5% down payment while investing the difference. The results are pretty interesting and well worth checking out.
Frugal Rules: An informative post from Pauline on things you need to consider before becoming a landlord. I think owning a rental property is a very interesting way to build wealth, but there are definitely a lot of things to consider before jumping into it.
Thrift Genuity: Greg has some good lessons for interpreting the language of a recruiter. As with anything else, make sure you understand their motivations before believing that they always have your interests at heart.
Journey to Saving: Nice discussion from E.M. on some of the pressure surrounding gift-giving. How do you handle it in your household?
The College Investor: Rob has some good advice for parents who want to help their high-schoolers get started with investing.
Done by Forty: Getting rid of 30 things in 30 days. I love this simple approach to de-cluttering. Each day is a small habit, but add it up over time and you get big results.
Thanks to these carnivals for including me along with some other great posts!
Carnival of Financial Independence
Carnival of Retirement
The Tortoise Banker Carnival
Photo courtesy of Omar Reyes