If you think that taking time out of your evening routine to research mutual funds and analyze annual reports is the recipe for amassing wealth, you need to understand that there’s a different path you can take: couch potato investing.
We like to compare couch potato investing to putting your investments on autopilot or taking a lazy investor approach to building wealth. It’s a simple method of creating a low-maintenance, diversified portfolio of index funds that will provide the returns of the bond and stock markets with little cost. You won’t make changes to your portfolio as frequently as you would while reacting to price movements.
Explore how couch potato investing can keep your investment strategy simple, and how you can use it to diversify the assets in your portfolio.
What is Couch Potato Investing?
Otherwise known as passive investing or index investing, couch potato investing is gaining momentum among investors who are looking to move away from the overpriced, actively managed mutual funds and stock-picking strategies meant to beat the market. With this passive investment strategy, you’re simply building a diversified, low-maintenance portfolio that can match the returns of the bond and stock markets at the lowest cost. You may reduce your associated fees by nearly 90% while outperforming most of the professionally managed accounts.
For the couch potato investor, activities like selecting individual stocks, timing the markets, and making economic forecasts are counterproductive. Instead, couch potato investors believe that you stand a higher chance of succeeding by owning the returns of the broad bond and stock market.
Couch potato or passive investors use this strategy to match overall market performance by putting money into low-fee funds, like index funds and exchange-traded funds (ETFs), which may hold nearly all (if not all) of the stocks and shares in a specific index.
By doing so, you’ll have your money in a balanced array of bonds and stocks that’s diversified by sector or industry, since indexes comprise all companies in a market rather than a few winners. Based on your risk-tolerance levels and investment goals, you can use different portfolio allocations aimed at building a portfolio that requires minimal hands-on management, say an 80/20 split between stocks and bonds.
The equity side of the portfolio helps drive growth while the bond side helps balance out stock risks and market volatility. Once a year, you may check and rebalance your portfolio to keep your target allocations for either security intact.
The couch potato investing strategy will probably limit you to a few balanced index funds, but you can still maintain diversification while keeping costs low by choosing the right funds. You can also build your portfolio from scratch using ETFs, which lets you enjoy ultra-low fees and a huge diversity of assets that you may tailor to your tastes. Top ETF providers include Vanguard, iShares, and BMO, though you can also access ETFs through an online brokerage.
Instead of limiting yourself to the simple basics, you can pick ETFs that focus on specific stock or bond categories: large-cap or small-cap companies, corporate or government bonds, dividend or non-dividend paying, among others.
What is an Index Mutual Fund?
Think of index mutual funds as smoothies whose ingredients are carefully measured to mimic popular stock-market indices. Mutual funds take a bunch of money from investors, put it in a large pool, and then a fund manager uses the money to invest in different areas, assets, or strategies. Index funds are typically built by portfolio managers, who construct a portfolio of stocks that tracks a specific stock index (think S&P 500) as accurately as possible.
If the fund manager does his job well, then in theory, the index fund’s share price should move in sync with the stock market index it’s trying to mimic, though this isn’t always the case.
Most index mutual funds are passively managed: the fund manager only tries to match or track a stock market index or other market benchmark, rather than using their own discretion to pick the best stocks for the mutual fund. And since the fund manager’s decisions are relatively simple and straightforward, the fees they charge are relatively low.
Index funds give you the opportunity to put your money in tens, hundreds, or thousands of stocks with a single purchase. For that privilege, you can expect about 1% of your investment to go towards the fund fee. Index funds may also provide good diversification if the underlying index being tracked is diverse. Remember, although a diversified portfolio may help spread out your risks, it doesn’t guarantee a profit or protection against a loss in a down market.
What is an Exchange-Traded Fund?
Some investors want to pick and invest in individual companies. Others want to put their money in multiple asset classes at the same time. ETFs are best suited for the latter stack of investors. An exchange-traded fund is a basket of securities designed to track an underlying index, so you don’t have to pick individual stocks.
There exist different ETF flavours that you can trade on an exchange. They can vary in their investment focus (tech or health), particular region (an emerging market or international stocks), or other categories of securities. You can also invest in ETFs that track bonds, currencies, or commodities.
Should I Use Index Mutual Funds or ETFs?
Index mutual funds and ETFs are quite similar since their structure follows a fund-holding approach. And although both can provide exposure or access to a wider range of investments in a single bundled fund, they have their differences.
For starters, you can trade an ETF throughout the day on an exchange, similar to stocks. ETF prices can move during the day, as they are bought and sold during trading hours. Besides providing real-time pricing, ETFs also let you execute sophisticated order types that give you more control over the price. On the flipside, index mutual funds are only priced once daily, usually at the end of a trading day.
Index mutual funds may be actively managed by a portfolio manager, so you can expect to pay higher fees for this service. ETFs often passively track the movements of a security or index with minimal human direction, so you won’t incur high management fees.
ETFs zeroing in on specific asset classes, commodities, or industries may provide exposure to specific market niches, which isn’t often available with index mutual funds. ETFs are also widely considered to be more tax efficient than index funds.
While you’ll need to assess your investment strategies and risk appetite, exchange-traded funds may be a better option if you’re looking to minimize costs, get more targeted exposure, and enjoy some tax sops.
Advantages of the Couch Potato Portfolio
Couch potato investing may not appeal to every investor, but here are some reasons why it pays you to be a lazy investor.
A couch potato portfolio often comprises index mutual funds and ETFs, both of which provide access and exposure to a broad mix of securities. In the case of a mutual fund, you can expect your portfolio to mimic the performance of a well-known index, most of which include hundreds of stocks.
Diversifying your portfolio with both equity and fixed-income securities also provides a hedge against losses during periods of bearish equity performance.
Another benefit of a couch potato portfolio is that it’s dirt cheap. Index mutual funds and ETFs are typically passively managed, so you won’t incur a huge cost for having your portfolio actively managed by a portfolio manager. And if you do incur charges, they will rarely exceed 1% of your investment amount.
Another attractive benefit of the couch potato strategy is the reduced investment risk. By nature, mutual funds and ETFs provide a largely diversified portfolio, which ultimately reduces your exposure to risks. After all, the returns of your couch potato portfolio don’t come at the cost of huge investment risks.
How to Set Up a Couch Potato Portfolio
Building a couch potato investment portfolio is far easier than you think — you can set it up from any sofa in the world. Nonetheless, there are two crucial steps you must take upon deciding that this is the investment strategy you want to pursue.
First, you must decide how you’d like to split your portfolio between bonds and equities. While the rules on how you should split your portfolio are not set in stone, it will all come down to factors like your time horizon for the investment, investment goals, and risk tolerance. You might go with an 80/20 split, 50/50 split, or anything in between.
Once you have a clear picture of how to split your portfolio, you can proceed to decide which funds to buy and how many. This can be the easiest step in setting up your couch portfolio as long as you pick index mutual funds that track the larger stock market or total bond market. An all-inclusive index means that you’ll have a well-balanced portfolio as well.
The heavy lifting is probably finished once you’ve successfully set up your couch potato portfolio with a brokerage. Moving forward, you’ll only need to log into your brokerage account once a year to see how your portfolio is weighted and how your funds are performing. You can adjust anything that seems out of balance to ensure your asset allocation remains within your chosen targets.
Asset Allocation and ETFs
When it comes to asset allocation in your couch potato portfolio, the decision on what assets to include largely comes down to the management expense ratios. Costs are important to consider if you’re looking to maximize profits, so you’ll want to keep them low if your portfolio is still small. ETFs usually carry lower management fees.
Besides management fees, it’s important to consider transactions costs, which can also be a nightmare for the inexperienced investor. ETFs are known to carry higher transaction costs than mutual funds, though they have the advantage of lower annual fees.
Asset allocation ETFs can help you build a balanced, low-cost portfolio. Most of them hold several underlying stock and bond ETFs, which you can invest in with a single trade. Compared to portfolios built from individual ETFs, asset allocation ETFs are considered more expensive and less flexible. Even so, they are a breeze to manage since all rebalancing work is done for you.
The balanced ETF portfolios from Vanguard and iShares give you the option of a portfolio that is 20%, 40%, 60%, or 80% equities. You’ll find one of these allocation options ideal for your situation. Both firms also offer an all-equity ETF that can be combined with a bond ETF in your preferred proportion.
Couch potato investing lets you take advantage of the set-and-forget approach to building a portfolio. This strategy may warrant your consideration if you’re looking for a less time-intensive way to grow your portfolio. Of course, you still need to weigh the strategy’s costs and performance against your financial goals before making the leap.
A financial advisor can provide you with most of the information you need and point you towards funds you may consider investing in.
Frequently Asked Questions
Where does the name Couch Potato come from?
The name Couch Potato was born on September 29, 1991, when legendary investor Scott Burns wrote a column in the Dallas Morning News. His suggestion was that investors put one half of their money in a fund that tracked the S&P 500 and the other half in a fund that tracked the US bond market. Scott assured investors that they’d only need to monitor their investments once annually. It is from this simple investment idea that the Couch Potato portfolio came into existence.
How safe are ETFs?
An ETF is just as safe as the stocks or securities it’s composed of. However, some highly diversified ETFs like the Vanguard All World ETF are considerably safer than individual stocks, provided you can hold them for many years. ETFs are a safe vehicle if your investment horizon spans at least five years. But if you might need your money sooner, it’s a better idea to invest less in ETFs.
What is the downside of ETFs?
Similar to other investment vehicles, ETFs also carry risk. Although ETFs can help you diversify your portfolio, they aren’t entirely diverse on their own. Some will limit you to a specific sector or region, so be sure you understand what comprises the ETF you’re looking to invest in.
Also, not all ETFs are low cost — there’s always management fee creep. Carefully look at the expense ratio of the ETF you’re looking to invest in. You may be surprised to discover that it’s quite expensive relative to a traditional index fund.