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Invest Like the Best: Indexing the Stock Market

On the road to becoming a financial badass, one major stop is the stock market.  In fact, no reasonable financial plan for a Canadian MD should exclude it.  Equities can be a fantastic vehicle for growing your nest egg, but only if the investments are made properly.

The first rule of The Canadian MD’s Guide to Becoming a Financial Badass is:

“Don’t speculate.  Invest.”  – MD Wealth

So what does this actually mean?

I think one of the best ways I’ve heard of differentiating the two comes from John C. Bogle, founder of the Vanguard Group (and an absolute financial rock star):

“Speculation leads you the wrong way.  It allows you to put your emotions first, whereas investment gets emotions out of the picture.”  – John C. Bogle

This means that the “next hot stock” is something we couldn’t care less about.  We’re not looking to hit a home run with our investments.  Remember the risk-return relationship of the market?  Swinging for the fence is way too risky when it comes to investing the money that we intend to use in the future to support ourselves and our loved ones.  If we’re going to do that, we might as well just go to Vegas and bet it all on black to save time.

It also means that our goal is never to “beat the market”.  Why not?  Because we can’t.  Not with any degree of consistency, anyway.  And the risks we run when trying to do so (and the fees we pay for even trying) are unacceptably high.  Also, despite what many active mutual fund managers and their sales people at your local investment offices may tell you, they can’t do it either.  The evidence has borne this out time and time again with alarming consistency.

To us, “investing” means that we don’t take unnecessary risks with our financial futures.  It means that we use the evidence (just like in our medical practices) to inform our investment decisions.  That’s what this post is all about….

We’ve talked before about the importance of proper diversification in our investment portfolios.  What this means when it comes to the market is that we want to be diversified across various businesses, sectors, markets, and economies.  While we could do this by researching individual companies in a multitude of different sectors, selecting the best ones, and buying their stock, it’s unnecessarily time-consuming and expensive to do.  We’d be much better off devoting that time to making more money at work or making more great memories with our loved ones.  Fortunately, there’s a better way to become diversified….

 

Mutual Funds

A mutual fund is an asset that we can purchase that consists of shares of stocks and/or bonds from a diversified group of many different entities (e.g., companies, municipalities, government entities, etc.).  While it may seem like a very good thing to have a pro pick your stocks & bonds for you, the unfortunate truth is that they don’t do this for free.  In fact, in Canada we have some of the highest mutual fund fees (known as MERs or Management Expense Ratios) of anywhere in the world!  What this ends up doing is significantly eroding the potential growth of your investments (and I’m not talking just a little bit – the effect is actually massive).

What’s more is that actively managed funds are constantly buying and selling shares of companies, triggering capital gains when the stocks have gone up in value and putting the investor on the hook for a tax bill for that capital gain when they haven’t even realized the gains themselves by selling the fund yet.

But the thing that really gets to me about mutual funds is that when they release their annual reports, the returns they quote conveniently leave these (and other important) factors out.  As Jack Bogle says:

“Surprise!  The returns reported by mutual funds aren’t actually earned by mutual fund investors.” – John C. Bogle

“But mutual funds are everywhere!?!” you might be saying.  Yup, they are.

“They must make up for the fees they charge by giving much better returns!?!”  Nope, they don’t.

Actually, to be fair, some do.  Very, very few.  In fact, they number in the few percent of all of the mutual funds out there in any given year.  And the big problem with that is that we have no way of knowing which ones are going to outperform in the future, so don’t think that you’ll be able to recognize them.  Another quote from Jack Bogle (In case you couldn’t tell by this point, I admit it.  I have a man-crush on this guy.) says it better than I could:

“Fund investors are confident that they can easily select superior fund managers.  They are wrong.”  – John C. Bogle

So what are we to do?  Well, we buy index funds instead.

 

Index Funds

Index funds are a type of mutual fund that is passively managed.  In other words, its holdings are dictated ahead of time based on a particular stock market index, which is just a measurement of the value of a particular sector of the stock market.  The index is computed based on the prices of a representative group of stocks. Examples of a stock market index are the S&P 500, the TSX, the Dow Jones Industrial Average, and the NASDAQ Composite Index.  An index fund consists of the stocks in that particular index.  My final quote from Jack Bogle (who is credited with the creation of the first index fund available to individual investors):

“Don’t look for the needle in the haystack. Just buy the haystack.” – John C. Bogle

By definition, an index fund does whatever its index does (minus a small MER and tracking error).  Here’s an example:

It turns out that, as long as your time horizon is fairly long, the fact that the index fund follows the index very closely is a good thing as the market tends to trend upward over time (about 6-8%/year on average).  In fact, when fees and other costs are factored in, index funds outperform 90-95% of actively managed funds.  This picture pretty well sums it up (the blue is how much of your investment you get to keep and the red is how much of your investment that the fund company gets to keep):

 

Exchange Traded Funds (ETFs)

A spinoff idea of index funds are ETFs.  ETFs behave more like stocks in that they are traded on stock exchanges but most tend to track an index like index funds do.  Because of their lower MERs, ETFs tend to be cheaper to own than index funds.

The downside to ETFs is that they aren’t cheaper to buy.  You can usually buy and sell index funds without paying anything in fees. As they are traded on the stock market, to make an ETF purchase, you usually have to pay a brokerage fee (although these are dropping all the time and some brokerages are even starting to offer a number of free trades).  Depending on how much money you’re investing (this is where the MER is important) and how often you’re planning to buy or sell (this is where the brokerage fee is important), running the numbers should tell you which one is right for you.

 

Here’s What I Do:

As I’m sure you’ve figured out by now, I don’t buy individual stocks or bonds and I don’t buy actively managed mutual funds.  I’m an indexer.

My strategy involves a combination of index funds and ETFs.  As contributions to my registered (this part is important) investment accounts are automated every month, I use that money to buy index funds monthly (a strategy known as dollar cost averaging).  Then, once per year, I sell the index funds (Remember the registered part? There’s no tax on the capital gains while that money stays in the account.) and use that money to buy the ETF equivalent of the fund (to maintain my level of diversification), incurring the brokerage fee only once per year and then taking advantage of the lower MERs of the ETF from that point on.

In another post, I break down the steps of how to pick the index funds and/or ETFs you should buy and how to do it.

 

Action Steps (30 minutes total)

  1. Make a list of the actively managed mutual funds you own
  2. Hop on over to the Ontario Securities Commission’s Investor Education website to calculate the MERs of those mutual funds: http://www.getsmarteraboutmoney.ca/en/tools_and_calculators/calculators/Pages/mutual-fund-fee-calculator.aspx#.WSpnthMrKRu
  3. Email the sales person who sold you those funds and find out if there are any fees for selling them right now (some of them have early redemption penalties).  Sell the ones that don’t.
  4. Take a look at my post on how to index.
  5. Do what it says (i.e., use the cash you accumulated from #3 to buy index funds and/or ETFs) and you’ll end up with a much better investment portfolio

 

What do you think about this indexing strategy for Canadian MDs?

Please add your two cents below.

 

And as always, if you found this helpful, please share it with someone you like on social media and/or email.

 

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