Setting Investment Goals with Index Funds

Establishing investment goals can be difficult given the number of uncertainties and complexity with time scales. Never-the-less, investment goals are useful in establishing how reasonable certain expectations can be. In this post, we depict a simple way to establish and assess long-term investment goals with index funds. This is good practice when you start out investing (or start to have a stable source of income) to give you a very realistic chance of achieving your goals.

Framework for index investment goals
Objective: How much do you want to have saved and for when.
Limitations: What is your time frame, starting investment sum, risk tolerance, etc.
Savings target: How much per year (or per month) can you add in contributions.
Portfolio model: Which portfolio model will you be following (article on portfolio models).
Rebalancing strategy: How often will you be rebalancing.
Monitoring strategy: How often will you monitor your investment and for what reason.

Let's look at an example:
Objective: Save $1,000,000 post-inflation (assuming 3%/year) in a TFSA for retirement.
Limitations: Invest for 40 years, with starting portfolio value of $30,000 at relatively low-risk (decent bond exposure).
Savings target: $5,500/year for first 10 years, then $6,000/year for remaining 30 years.
Portfolio model: Following the bond-by-age model (to lower risk exposure with age).
Rebalancing strategy: Once a year.
Monitoring strategy: Monitor investments biyearly, if an index ever shifts 10%+ in this time period, rebalance portfolio.

We also need to make an assumption on the annualized return of the modeled index portfolio. If we assume it generates 7.5%/year, this would represent a post-inflation corrected return of 4.5%/year. Will we achieve our goal?

While the graph looks great, under the given conditions, this portfolio will only be valued at $829,376 after the 40 year period (with a 3% annualized inflation correction). By knowing this, we can play with certain conditions to place ourselves in the best situation possible to achieve our investment goals. For simulation purposes, conditions we can change include: starting investment sum, investment time period, contribution amount/frequency and expected annualized rate of return. For example, if we were somehow able to begin investing with $58,200 instead of $30,000 with all other conditions unchanged, we would end up with $1,000,778. If markets performed better than expected and we averaged 8.5% annualized (5.5% post-inflation), without changing any other conditions, our portfolio would be worth over $1.1 million. I recommend you set your investment goals and apply some conservative conditions and then some slightly optimistic conditions, so that you can have an idea of the realistic range of expected return.

Post below if you have any questions and thank you for reading!


-Yinvestors.



keywords: index fund investment strategy, investing framework, index funds, index portfolio, inflation, rate of return, investing goals.

What is Couch Potato Investing

The term 'Couch Potato' is perfectly defined by the Urban Dictionary as:

“A lazy person who does nothing but sit on the couch and watch television.”

It comes with fantastic synonyms like: slacker, lazy, bum and slug.

That doesn’t sound too much like a life goal, but it actually does present a viable strategy for investing. A couch potato investor would be a passive investor who deals with his investments once a year. The rest of the year, this investor may or may not contribute to their investments and they may or may not even care to see how their investments are performing. How could this possibly be a good strategy?

1) You are not being emotionally influenced by short-term market fluctuations. How can you be when you’re not even looking at your investments! If you hold a balanced index portfolio, you are so heavily diversified that any short to medium-term swings will likely be insignificant. Not tracking your performance daily or even monthly allows you to keep an eye on the bigger picture, which is long-term growth.

2) You are avoiding heaps of fees. While you may have free transactions if you are buying e-series or other index funds, ETFs tend to come with commissions. The more you trade, the more fees you accumulate. By trading only once a year (adding to investments and rebalancing) you are limiting fees while maintaining some level proactivity.

3) It’s an easy approach. Yep, being lazy is easy. A couch potato investor might deal with their investments for an hour or two a year and achieve better returns than their neighbour who spends nights trying to find the next hot stock. You could know next to nothing about the stock market and still carry out a couch potato investment strategy (and obtain solid results), making it an attractive option.

The key concept here is that a couch potato investor keeps things simple, there is incredible power to simplicity when it comes to investing.  

To expand on index investing, taking the couch potato approach can be very beneficial to youth investors. One of the key objectives is to begin investing at a young age and use time to your advantage (as depicted in our previous article: The Power of Time). Most young people tend to know little about the stock market and investing, creating a barrier to entry as investing is viewed as being immensely complicated. In most North American education systems, business literacy is given little importance. It is also viewed as a personal topic and rare that people will openly discuss their finances. Most youth likely have little idea what their parents’ true financial situation is (and nor do their parents tend to want to talk about it). This results in young people making bad financial decisions as no one has taught them how to deal with money. Getting involved in index investing is perfect for young people as it is a passive approach that doesn’t require deep market knowledge to be effective. So, for once it may actually be a good idea to be a couch potato.

If you enjoy the article, please help share and give the blog a Google+ follow! Learn how you can begin investing in index funds.

-Yinvestors.

keywords: couch potato investing, index investing, what is couch potato investing, index funds Canada, e-series, index investing strategy. 

Choosing an Index Portfolio Model

We discussed briefly in the 'Combining a Tax-Free Savings Account and Indexing' article about how to balance your index fund portfolio, but it is a fundamental step in getting started and worth discussing more in-depth. How you first set up your index portfolio will likely impact how you invest for years to come.

The purpose of having a balanced index portfolio is to increase exposure to various markets and investment types. A common strategy for North American investors is to include the following four index types:
- Canadian Stock Index
- U.S. Stock Index
- International Stock Index

- Bond Index

For the U.S. stock index, you can either choose an S&P 500 index or a Nasdaq Index. I tend to prefer an S&P 500 index as it consists of more companies. For example, the e-series Nasdaq index actually consists of 110 investments, while the S&P 500 index consists of 504 investments. Regarding the bond index, you should obtain one that is in your local currency. The reason for this is that currency fluctuations can often be greater than bond returns. Since you are looking to get bond exposure, not currency exposure, sticking to a bond index in your local currency is most logical. An international stock index will typically consist of the some of largest international markets combined as one unit. If, for example, you only wanted to invest in European stocks, you could purchase an all-European stock index instead.

Great, so now we have an idea of what to buy, but how much to buy of each? There are four general strategies you can follow as a balanced index investor:

Strategy 1: bond allocation = age
(example for a 22-year-old investor)
Bond Index (22%)
Canadian Stock Index (26%)
U.S. Stock Index (26%)
International Stock Index (26%)

One effective and common solution is to set your bond percentage allocation as your age and to then split the remaining allocation across all stock indexes. As in the example above, a 22-year-old investor would place 22% in a bond index and split the remaining 78% across the three stock indexes. One advantage of having this strategy is that your bond allocation naturally increases over time. Meaning you are gradually decreasing risk exposure with age while having substantial stock exposure at a younger age, giving you a chance at greater returns.

Strategy 2: even distribution across all indexes
Bond Index (25%)
Canadian Stock Index (25%)
U.S. Stock Index (25%)
International Stock Index (25%)

This option is great for simplicity and offers strong stock exposure, but you are not reducing risk over time.

Strategy 3: bond index heavy
Bond Index (70%)
Canadian Stock Index (10%)
U.S. Stock Index (10%)
International Stock Index (10%)

An option for a low-risk portfolio still with some stock exposure. This option will be the least volatile, but will generally have the lowest average expected long-term return.

Strategy 4: stock index heavy
Bond Index (10%)
Canadian Stock Index (30%)
U.S. Stock Index (30%)
International Stock Index (30%)

An option for a higher-risk portfolio still with some bond exposure. This option will be the most volatile, but will generally have the highest average expected long-term return.

Pie Chart Overview of the Four Index Portfolio Models

These are only some general models you can follow. You can select indexes and set percentage allocations are you see fit for your own situation. Keep in mind that greater stock exposure tends to represent greater risk but greater potential rewards.

Steps Overview:
Step 1: decide which types of index funds you want to invest in. I recommend choosing between 3-5 indexes, including a bond index in your local currency.
Step 2: decide which portfolio model strategy you want to follow. If you are unsure, I would recommend going with the first option (bond allocation=age).
Step 3: if you already have an investment account, you can now place orders! Continue to rebalance to your original allocations through contributions (at least once a year).

If you have any questions about portfolio models, comment below!

Here are some of our other articles on similar topics:
Best Index Funds and ETFs (Canada)
The Case For and Against Rebalancing Your Index Portfolio
Adjusting Your Index Portfolio During Market Downswings

-Yinvestors.

keywords: index portfolio models, index investing, e-series, bond index, stock index, how to balance my index portfolio, S&P 500 index, index funds. 

Adjusting Your Index Portfolio During Market Downswings

Theres no doubt markets are off to a horrible start to begin the year. Here is the current overview of North American markets to start 2016:

Dow Jones (8.67%)

S&P 500 (9.40%)

Toronto Stock Exchange (6.34%)

And many of the international markets are doing even worse. It's not exactly all sunshine and rainbows at this point. So, how can you respond effectively to this?

Stick to the same strategy we've been talking about since the beginning.

Continue with your monthly contributions but now you will likely be splitting them between the stock indexes only to increase you percentages back to your original allocations. If you are unable to contribute enough to your investments to reset percentage allocations, consider selling off some bond indexes (which have remained relatively stable this year) and buying more stock indexes instead. If you have not read our blog post on discussing % allocation click here.

All you can do is make the best of the situation and put your money to use so that it can build on itself in the future. If you were comfortable with buying S&P 500 stock indexes at the end of 2015, they are now at a 9.4% discount! It would be illogical to put off on buying more given we do not know the future of the market. Continue with the strategy and variance will ride itself out.

Stock may continue to drop, they may rebound, they may do a mix of both, no one knows. By continuing to buy during lows, you stand to benefit from downswings by having bought cheaper units. When upswings do occur, you will be there to reap the benefits.

In 2008 when the market crash occurred, the Dow Jones ended down 33.84% on the year (S&P 500 was down 38.49%) only to then rise for the next 6 years. The losses were more than made up for. The cheapest index units you could've possibly bought over the past 10 years were during this recession. Savvy index investors should think of the word opportunity when markets crash.


-Yinvestors.


keywords: index, index investing, stock market, index balancing, rebalancing index, index funds, e-series, S&P 500 index, S&P 500, TSX index, DJIA index, U.S. stock index, Canadian stock index, Canada index.
Graphs source: Yahoo Finance 

The Power of Time (and why you should start investing now)

I often see over the internet people asking questions such as:

- "I am 17 and want to learn about investing, where do I get started?"

- "I am a college student with $5,000 to invest, what are my options?"

- "Can I start investing with $1,000, and how?"

These are all questions that cross the minds of many young people and, to some extend, depict how our education system has failed. It is fascinating that so often business/investment education is not a critical aspect of education systems, while managing and investing money will be of fundamental importance for the rest of our lives. This blog is motivated to help people find answers to such questions in a simple manner so that they have a starting point to develop their investment strategies.

Regarding the last two questions that depict some fix amount ready to invest, some answers I have seen were that it's a small amount and probably not worth investing. While having $1,000 to invest will not give you much flexibility to trade individual stocks (commissions will eat your money away), you definitely have some options! Two clear-cut options are to buy bonds or index funds, where you will face a percentage fee that will be low due to your investment amount.

So is starting to invest $5,000 today worth it? Let's have a look.

We will assume our passionate youth investor has $5,000 and will be building himself a well-balanced index portfolio that yields him 7% annualized average. We will assume that over the years, he will contribute $1,000/year to his investments. Let's watch how his money grows over 50 years:

After 50 years, our investor is now a bit older and has contributed a total of $55,000 to his investment portfolio ($5,000 to start and $1,000/year afterwards). His portfolio value is now a staggering $553,814! How is that possible? Well, your best friend when it comes to investing is time. The younger you are, the more time you have to make your money work for you. Even if it is a small sum, it really does add up. That initial $5,000 alone would be worth $10,000 after about 10.5 years and by the end of the 50-year period, it would be worth $147,285.

Let's look at some of the assumptions here. First off, you never paid any taxes on your earnings, which could be the case if you made use of a TFSA. Second, a 7% return annualized is achievable with a balanced index portfolio, although if you were to hit a downswing right out of the gates, this would significantly impact you down the line (given your initial capital is 5x your yearly contribution). In this example, we simply assessed 7% as a linear return, which would not be the case, some years your might lose 5%, some years you might gain 12%. Regardless, the example does depict the power of time.

Let's now look at a different case, let's compare the same investor who decided to spend his $5,000 and held off investing for another 10 years. Can't be that bad can it? Well let's have a look over that same 50-year period:

So actually, it's pretty significant. In the second case, a total contribution of $45,000 has been made, as compared to $55,000 in the original case (an extra 10 years at $1,000/year contribution). Let's look at the end result though: our delayed investor has a portfolio value of $274,507 versus the more diligent investor with $553,814 - over twice the amount! How is that possible? Again, think back to compounding. The 7% you made your first year off the $5,000 has made 7% from itself every year, this progression reiterates itself every interval and for your contributions. This is how you can establish wealth off not much starting capital!

The sooner you begin investing, the better off you will be. Even a small sum can grow into a fortune under the correct conditions. Don't listen to those telling you a small sum isn't worth investing! You have to start somewhere and if the small sum even just motivates you to save up money, it is immensely valuable.

Here is a link to the table breaking down the number for the graphs depicted above (graphs may not load, but table works). Comment below if you have any questions and please give the blog a G+ follow! More posts on similar topics coming soon!


-Yinvestors.


keywords: youth investing, compounding interest, compounding growth, growing money, how to make money grow, investing, money growth, index funds, index investing, money. 

Index Funds and Mental Strength

One of the key characteristics of good long-term investors is drawing the line between making sound investments and emotions. When the stock market crashes, it is common for people to panic and sell off their investments without really understanding why this is happening and being critical as to whether the quality of their investments is still present. Logically speaking, if the quality of the stock has been maintained but the overall market is tumbling, the stock is becoming progressively cheaper. This is an easy concept to understand, but much harder to practice when your life savings are on the line. The emotional element of investing outlines why smart-analytical people can become losing investors. In this article we will discuss why index funds provide emotional comfort when investing in the market, which may be especially important to youth encountering monetary swings for the first time. 

With the correct mindset and investment strategy, managing
your investments can be an enjoyable experience! (source)

Not Trying to Predict the Market

When investing in indexes you are not trying to predict the market. For the most part, you are adding to your investments along the way - at least once a year. By continuously adding to your investment you are reducing variance over the long term. For example, if a given index is down 5% a certain month, through monthly contributions you are lowering your average cost per unit. Not trying to predict the market also means you do not hold off on adding to your investments because the market seems expensive. Even if the market is at a 5-year high, if you choose to hold off on contributing to your portfolio waiting for it to drop, you are somewhat trying to predict the market! What if the market remains relatively stable for the next five years? What if it rises another 20%, or what if it drops 20%? How will you know if it will not drop another 30%? Money is better invested and contributing to dividends since market dynamics are excessively complicated and impossible to predict over any extended period of time. Following the same principle, if you are about to contribute to your investments but markets are tumbling, is it worth waiting? The concept of trying to predict the lowest an individual stock will fall is referred to as 'catching a falling knife'. No one knows how low it will reach and if you misevaluate, you might get cut. This principle somewhat applies to index investing. If you are worried about the state of the market, you could choose to contribute your money in smaller amounts and more often instead.

If you are limited in your ability to add to your investments, another potential strategy would be to keep a certain (but small) percentage of your portfolio in cash, say 5%. This may be a more legitimate strategy to investors buying individual stocks as by the nature of their investments, their portfolios will be less diverse. Meaning it is more likely for a market crash to impact all your investments, versus an index investor than has money in foreign markets and bonds. Having a fix cash allocation gives you the flexibility to buy cheaper units of stocks or index if markets slump. For Index investors, owning bond indexes in your account that provide more stable returns and still give you buffer to rebalance may well be a better strategy. 

You Cannot Blame Yourself for Swings

One of the benefits of owning a well-balanced index fund portfolio is that the swings will be much smaller as compared to owning individual stocks. When substantial swings do happen, it will be because of global market dynamics that no one could've predicted accurately. This means that as an investor, you should be rather emotionless towards swings. You cannot be down at yourself for your recent stock purchase, since you've bought the whole market! By having your money invested in indexes, you are giving yourself a chance at experiencing greater returns than fix investments and keeping ahead of the inflation curve. On average you are making a winning investment. The greatest swing the DJIA experienced in the last 10 years was 7.87% in one day (which is a massive swing for an entire market). If you had 30% of your portfolio allocated in the DJIA, you would've experienced a decrease in value of (0.3*0.00787)*100=2.36% in portfolio value (or $236 on a $10,000 portfolio).

Another key characteristic that distinct index investing versus common stock investing is the risk assessment of losing your entire capital. Assuming that the company managing the index is reputable (such as Vangaurd, BlackRock, banks etc.), it becomes effectively impossible for an index portfolio to go bust. You would need major governments (provincial and federal) to fail to meet bond payments and all major companies to go broke, both domestic and international. Taking the concept of 'too big to fail' to a whole new level.

Remain Realistic About Your Investments
Regarding the mental game, it's also important to be realistic about market returns and understanding that investing in index funds requires a long-term outlook. It's very possible that you could lose money on your investments over some period of time, this does not mean you are making bad investments! Markets fluctuate year-to-year, but do go up on average. Keep a long-term outlook and continue to lower your average cost per index unit during index slumps.

Post any questions below and give a Google+ follow!


-Yinvestors.


keywords: index investing, index funds, mental strength, market dynamics, e-series, index funds. 

What Exactly is an Index?

- Sure all this index talk sounds great, but what really is an index and how does it represent companies in the market?

The most simple way to explain an index is that it is a list of stocks.

You have common indexes such as the Dow Jones Industrial Average (DJIA), Standard & Poor's 500 (S&P 500) and Nasdaq that consist of the largest public companies in the U.S. In theory, you could create you own index and track some segment of the market. For example, you could create a Canadian banks index, decide on a weighing system and track it over time to depict how banks as an index unit are doing. Indexes provide a simple way of tracking a group of stocks without having to process too much information. It's all about reducing sample size to gain a general image of market dynamics.

- So where did this all start? And how does it actually work?

The first Index was created in 1896 by Mr. Dow and appropriately named the Dow Jones Industrial Average. At the time, it consisted of 12 of the biggest companies in America (today it consists of 30). The value of the DJIA was established by adding the the prices of the 12 companies together and dividing by 12, providing a simple average. While there are flaws in doing this, it was a simple and efficient enough method at the time. 

It is now more common to use a market capitalization (market cap = share price * number of shares outstanding) method of weighing companies within an index. For example, if a company has a market cap of $5,000,000 and the complete value of all stocks in the index is $500,000,000, this company would represent 1% of the index. Let's say the stock dropped by half in value, while all other stocks remained unchanged, the index would drop by 0.5% in representative value. To calculate the actually price of an index, an index-specific divisor is used. The divisor accounts for structural changes within companies, such as share repurchases and mergers. In the example of the S&P 500, the sum of all 500 market caps are divided by the divisor, giving the index level (or value of the index). To give an idea, the current index level of the S&P 500 is $1880 and has a 52-week range of $1812-$2134.

- So why does knowing this matter?

As an investors, its always beneficial to be knowledgeable on what you're buying. Understanding how an index price fluctuation actually relates to individual stocks can be beneficial (and vice versa). You may also be interested in assessing how heavily weighted some of your favourite companies are within their respective index. Understanding how an index is designed can also help you asses the effectiveness of your index fund. For example, the three biggest companies in the S&P 500 are: Apple, Google (Alphabet) and Microsoft. An effective index fund should probably hold these companies as their top holdings, as they will have the most influence of any company on price fluctuations of the index (remember they are weighed by market cap!).

Knowing how an index is computed also depicts how an index could be down over a given time period while most of the stocks within the index could actually be up. This could be the case if a few stocks (or specific industries) in the index were down significantly, bringing down the complete index.

- How does this relate to index funds?

Index funds track these major indexes by purchasing stocks of many (sometimes all) of the companies within the index. You can expect that your index fund will have top holdings of the largest market caps within an index. Looking back to our article on the top holdings of e-series, for TDB 902 (S&P 500 index fund), the top 3 holdings were in fact:

Apple Inc. (3.3%)
Alphabet Inc. (2.5%)
Microsoft Corp (2.5%)

The metric used to asses how well an index fund tracks its target index is R-squared. R-squared is a common statistics metric that asses the strength of correlations between two sets of data. The values range from 0-100%, where 100% would present a perfect fit. When assessing the effectiveness of an index fund, you'd expect this value to be in the high nineties. For example, the 1-year R-squared value of TDB 902 is 99.00%, its 3 year value is 98.70% (Yahoo link). This signifies the index fund has been very accurate at tracking the S&P 500.

If you have any questions regarding indexes, comment below! Happy investing!


-Yinvestors.



keywords: index investing, index funds, what is an index fund, e-series, index, what is an index, index funds Canada, stock indexes, how does an index work