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Friday, April 25, 2008

How to Invest Your RRSP for the Long Term

Today I'm going to tell you how to invest your RRSP for the long term, and beat the returns of about 75-80% of the mutual funds out there. This addresses long term investments only, not RRSP funds that you plan on liquidating in 2-3 years for the Home Buyer's Plan (HBP) for example. If you're saving for the downpayment on a home, you will want very low volatility on those savings, so go with a decent GIC or Altamira's Cashperformer or other money market type funds. Once you start paying your HBP withdrawal back to yourself, then you can follow this long term approach.

This approach in the industry is often called the couch potato portfolio or other names which implies a passive technique to your investments. I'm giving you my little spin on it as well. The idea behind the approach is to simply buy a set of low cost index mutual funds. What do I mean by low cost? Well, I mean low cost in terms of how much the fund manager charges the fund to do his job. These management charges are referred to as the MER (Management Expense Ratio) of the fund. The MER is expressed as a percentage, which reflects how much of the fund is bled off every year by the fund manager to pay himself. The beauty of index funds is that there is very very little work for the fund manager to do since it's the index (eg. DOW Jones Industrial Index, or S&P 500) which dictates exactly what the fund will hold. Since there is hardly any work for the manager to do, he charges a very low MER for the fund. This leaves more money in the fund to experience compound growth.

The common stock market indices typically reflect a large diverse basket of high quality stocks. Active fund managers typically buy and sell stock within their managed funds to try and beat the index. Some years they do, other years they come up short. But every year they bleed off the MER from the holdings. The net result is that over the long term, 75% of active fund managers fail to beat the index. They would rather you not know this!

So armed with this new knowledge that index funds beat most managed funds in the long term, let's go forward with the couch potato portfolio approach. The approach is simple, with the main rule being "take your age in years and put that percentage of your RRSP into a Canadian bond index fund (DEX Universe Bond Index)". For example, if you're 40 years old, then 40% of your RRSP should be in a Canadian bond index fund. The idea is that as you age, you should have more of your holdings in bonds which are typically much less volatile than stocks. The rest of your portfolio (in our example, 60%) should go into the stock market via index funds, and you have a few choices here.

Approach 1: All Canadian
Buy a Canadian stock index fund. Your complete portfolio only contains two index funds, namely your bond fund and the stock fund. In our example of a 40 year old, his RRSP consists of 40% Canadian Bond Index (DEX Universe) and 60% Canadian Stock Index (S&P TSX Composite)

Approach 2: North American
Split your stock component equally between Canadian and American index funds. With American funds, there are typically two to choose from, namely the Dow Jones and S&P 500. So the 40 year old example would look like:
40% Canadian Bond Index
30% Canadian Stock Index
30% Dow Jones Index or S&P 500 Index. Or you could instead do 15% each for more diversification.

Approach 3: Global
Split your stock component equally in three pieces, namely Canadian, American, and International. So the 40 year old example would look like this:
40% Canadian Bond Index
20% Canadian Stock Index
20% American Stock Index (could be 10% each Dow and S&P)
20% International Stock Index (eg. MSCI EAFE Index)

It's called "couch potato" because you have nothing to do except once a year, near your birthday, rebalance the holdings so that the percentages are back to where they should be. Let me make this even easier for you, and point you to some specific funds. I like the TD efunds, since they are essentially setup exactly for this. The "e" means that they are environmentally friendly (or electronic) in that no paper will ever be mailed to your door. Instead, they send transaction slips to you electronically. The paper/printing/mailing savings are passed on to you in the low MER. Also, they offer no advice/personal contact and again the savings are passed on to you.
They also have currency neutral versions of some funds if you don't want to expose yourself to other currencies such as the US dollar or Euro. But one can argue that it is good to diversify yourself a bit out of Canadian dollars. The beauty of these funds is that you can hold a bit of each type if you like, namely the currency neutral and non-neutral version. By blending the two versions of any given non-Canadian index fund, then you can precisely control your exposure to foreign currencies. This may make a good future blog topic.

There are other index funds you can use to accomplish the technique, including exchange traded funds (ETFs). Ishares are one such example: . But keep in mind that you will need a brokerage account to buy and sell these units, and that will add some extra cost on top of the (albeit very low) MER.

Other banks and fund companies offer similar index funds, but I recommend that if you cannot easily find the MER for such funds listed on their website, then just take a pass. It irritates me that some fund companies make you download a prospectus and go searching through it to try and find the MER. It smacks of them having something to hide.

I hope you found this interesting and educational. Investing doesn't have to be hard. Oh, and by the way, you can apply this same investing technique to your holdings outside your RRSP. There is nothing really RRSP specific to this technique except that it is geared to the long term. Please don't forget to rebalance your holdings near your birthday!!!


Ricardo said...

Hey excellent post! I have been recently looking into this and this post was really helpful. I think I will also go with the TD efunds. Good job.

Jim Somerville said...

Thanks, I appreciate the feedback.