Reboot Your Portfolio, by Dan Bortolotti – A Review
As I wrote on my website, one of the major reasons I began to work in financial planning is because I saw multiple DIY portfolios that were not founded on any rational approach to investment planning. Many seemed to view investing as a variation on the lottery.
One of the best sources for learning the basics of a DIY investment plan has been Dan Bortolotti, formerly a journalist and now a portfolio manager with the Toronto office of PWL Capital. Bortolotti is the founder of the Canadian Couch Potato blog, perhaps the premier go-to source for learning about index investing in Canada. In case you think that Bortolotti no longer practises what he preaches, his office uses broad-based index-tracking Exchange-Traded Funds (ETFs) for their clients’ portfolios, not actively managed mutual funds or individual stock selection.
Although Bortolotti draws up and implements investment plans for clients now, he still has an abiding concern for the Do-It-Yourself investor, with his new book, Reboot Your Portfolio: 9 Steps to Successful Investing with ETFs, published on November 1, 2021, the latest expression of that concern.
Step 1. Stop trying to beat the market
According to the book, the first step to successful ETF investing is to “Stop Trying to Beat the Market.” In essence, this chapter is an argument for following the evidence. Investment advisors and their mutual fund dealers will often argue that, through active management, they can deliver an investment portfolio that will produce returns that are superior to the returns of the market. Indeed, not only will they provide better returns in up (bull) markets, but in down (bear) markets, they can apply their active management skills to get out before the bears have their day.
To be clear, Bortolotti is not arguing against mutual funds as an investment vehicle; in fact, in terms of ease of use, the mutual fund structure is easier to manage than the ETF structure. You can buy mutual funds in dollar amounts rather than by the number of shares, you can place orders any time of the day, rather than during market hours only, and you can set up pre-authorized systematic investment plans rather than having to do the trading yourself. Rather, the evidence points to the challenge being a combination of high fees and mediocre performance.
High fees may not be surprising given the extra research necessary to select from the available universe of securities, but mediocre performance is precisely what active management is supposed to avoid. However, when you compare the performance of the universe of actively managed mutual funds against their respective benchmarks, which are typically the indices of stocks and/or bonds from which the fund managers select, you will find that many mutual funds are unable to meet their benchmarks after fees. And among those that do achieve benchmark-beating performance, seldom do these funds find their superior performance persisting over time. You might argue that you, or your advisor, will only choose superior performers, but there are thousands of mutual funds that underperform their benchmark indices each year; where did the fund go wrong, and where did you or your advisor go wrong in choosing that fund? This book argues that the high fees and inconsistent performance of many actively managed mutual funds often make them a poor choice relative to index-tracking passively managed alternatives.
Step 2. Set your financial goals
After you have opened yourself to the alternative of index funds, the second step is to “set your financial goals.” This gets to the point of investing, which is not about striking it rich overnight. Are you saving for your retirement, for your children’s education, to leave them an inheritance, or to pass on a substantial sum to a favourite charity? Money, saving, investing – these are the means to your desired end, not the ends in themselves.
At its most basic, four questions need to be answered: (1) How much money will you need? (2) When will you need it? (3) How much are you currently saving? (4) What rate of return will you need to reach your target? The answers to these questions need to be realistic, of course.
Even if your plans are realistic, a financial plan has limitations and cannot anticipate every situation. I like this analogy: “A financial plan is not meant to be a detailed map that will tell you the exact location of every straightaway, speed bump, or hairpin turn. Think of your plan as a compass that will keep you pointed in the right direction, even if you never know exactly what lies ahead” (p. 34).
Since many Canadians have not saved adequately for their retirement, Bortolotti elaborates on how to save, when to prioritize paying off debt, and the various tools that Canadians can use to save, such as pension plans, RRSPs, and TFSAs. He also points out that fretting over fees makes less of a difference when your investment portfolio is more modest because the key point is not the returns as much as the amounts being put away (pp. 44-46).
Step 3. Find the right mix of stocks and bonds
The third step is to decide on an appropriate asset allocation, that is, the right mix of stocks and bonds. Bortolotti notes, “there is no such thing as a risk-free investment. Building a portfolio is about finding the right balance between risk and reward,” which depends on your capacity, your need, and your emotional tolerance for risk, or as the author puts it, “your situation, your goals and your stomach lining” (p. 50). While stocks tend to perform better than either bonds or cash, they can be extremely volatile, so your ability to tolerate the ups and downs of the stock market in return for potentially better long-term returns is important. It does no good to invest too aggressively if you cannot stick with the plan at the first sign of a downturn.
Some might argue against investing in bonds at all, given the low interest rate environment we are in. This leads to a discussion of correlation, that is, the extent to which one type of investment asset tracks the performance of another asset. Classically, bonds have a low correlation to stocks, which means that an investment portfolio with a mix of stocks and bonds can do better than a portfolio of stocks alone, relative to the risk the investor experiences. This is referred to as “risk-adjusted returns” (p.62).
Step 4. Fine-tune your asset allocation
Given the importance of asset allocation to an investor’s long-term returns, Bortolotti further hones the selection of assets within a portfolio. It’s not just stocks and bonds, it’s stock and bond (or fixed income) ETFs from a variety of asset categories. While the fixed income portion can be met by domestic, i.e., Canadian, bond ETFs or Guaranteed Investment Certificates (GICs), stock (or equity) ETFs need to come from a wider source. Bortolotti then goes on to point out why a substantial portion of one’s investments should come from the USA and other foreign markets, both developed and emerging, and also why Canadian equities should make up an outsized portion of the overall equity allocation.
Now, holding an outsized portion of one’s assets in Canadian stocks is probably not the advice most Canadians need to hear. Reports indicate that Canadians hold about 60% of their equity allocation in domestic companies. Given that Canada makes up not quite 3% of the global stock market, an outsized portion actually starts at a much lower level than the average Canadian investor’s holdings. A study by Vanguard suggested that if Canadian stocks made up about 20 to 40% of the equity portion of the portfolio, they would perform the valuable function of reducing volatility while not taking up so much space that they eliminated the positive impact of diversifying beyond our home country (p. 78).
While this summary of the book is already getting a bit long, I do want to comment on the section, “Stuff you don’t need.” Among those unnecessary investment products are Real Estate Investment Trusts (REITs), preferred shares, real-return bonds, high-yield or “junk” bonds, and gold (pp. 84-88).
Step 5. Select your ETFs
Since the author recommends, broad-based index-tracking ETFs, it is not a surprise that he begins this step with a discussion of the various stock indices that would go toward making up a suitably diversified portfolio of ETFs. The traditional way to create an index is to weigh the impact of a given stock by its relative size in the market. This is referred to as capitalization weighting or more commonly, “cap weighting.” In Canada, the S&P/TSX Composite Index tracks about 250 stocks that make up about 70% of the market capitalization of the Toronto Stock Exchange.
In the United States, the major index is the S&P 500, which tracks the shares of 500 of the largest companies in the US, again, using cap weighting. Other indices track the shares of 3,000 companies or more and typically have the word “total” in their name. People who avidly follow the “Dow,” the Dow Jones Industrial Average, may appreciate the caution expressed in this paragraph against using this particular average for gauging the stock market. Two things to note about the Dow are (1) that it consists of only 30 companies, hardly a representative sample, and (2) that the companies are weighted by price, not company size.
While each country with a developed stock market will have its own stock index, for most Canadian investors’ purposes, an ETF, that follows a broad-based international developed market index such as the EAFE (Europe, Australasia, Far East) Index, created by Morgan Stanley Capital International (MSCI) is more suitable than buying an ETF from 40 or more different countries. For international emerging markets, another common source is the MSCI Emerging Markets Index, which includes companies from countries like China, Taiwan, South Korea, India, and Brazil, among others.
There are many different indices, and consequently, many different ETFs. Not all indices are created equal, though. Is the index is broad and inclusive or narrowly rules-based? Additional questions: Are the constituents (the companies included in the index) liquid, that is, are they traded in sufficient volume? If a small market is dominated by one or two major companies, is there a system to cap the influence of that company on the index? Here, Bortolotti refers to the impact Nortel had when it rose to make up a third of the Canadian index before crashing into bankruptcy (p. 99).
Bortolotti recommends ETFs that follow broad-based cap-weighted indices for three reasons: 1) they are most representative of the stock market; 2) they are usually significantly less expensive than ETFs that track alternative or esoteric indices; and 3) they have the least turnover, which means that they are more tax-efficient in non-registered accounts.
By making his choice clear, Bortolotti both implicitly and explicitly, questions the value of equal-weighted indices, so-called Smart Beta or Factor investing. Another option he discourages is currency hedging, pointing out that, over the long term, it is impossible to tell whether hedging will or will not help. Evidence also indicates that the impact of currency movements tends to lower volatility over time.
Step 6. Open your accounts
While Reboot Your Portfolio is aimed at the DIY investor, Bortolotti observes that not everyone can manage their investments. He works as a portfolio manager himself, exemplifying the full-service option, and also discusses the “robo-advisor” option before going into the full DIY approach using an online brokerage. An important part of the discussion here is costs, specifically administrative fees and commissions.
In addition, to open your new accounts you need to know which accounts to open. The two that Canadians will typically start with are Registered Retirement Savings Plans (RRSPs) and Tax-Free Savings Accounts (TFSAs), although those with children will want to consider Registered Education Savings Plans (RESPs), and those who can maximize their contributions to these registered accounts would need to consider non-registered taxable accounts, too.
One more section in this chapter that I found delightful was the part about cutting ties with your advisor and the warnings against index investing with ETFs that you will likely receive.
- Index funds offer no chance of beating the market.
- Active managers can protect you during a downturn.
- ETFs are dangerous.
As you can imagine, each of these arguments is thoroughly rebutted.
Step 7. Build your portfolio
This chapter is the “how-to” section for placing a trade. Unlike mutual funds, which trade only at the Net Asset Value per Unit (NAVPU – or NAV) once per day, ETFs trade throughout the day between 9:30 am and 4:00 pm Eastern Time, and you have to contend with both bid and ask prices. Further, since you have to buy in whole shares and not in dollars, you have to do some calculations. While it may seem straightforward, it can be challenging. Speaking personally, I have seen DIY investors place orders that have been different than they have intended in multiple ways: 1. Wrong security; 2. Wrong order type; 3. Wrong account; and 4. Wrong currency quickly come to mind. Bortolotti rightly emphasizes getting these details right and helpfully points readers to his colleague Justin Bender’s website, the Canadian Portfolio Manager Blog for some video tutorials on placing a trade. As I write this, there are 46 different videos; you will want to look at the oldest dozen or so for guidance on placing trades.
Some highlights: use limit orders, not market orders; if your broker charges a commission, reduce the impact of the commission by making fewer larger trades rather than smaller more frequent trades; don’t place orders outside of market hours; be aware of differences in US and Canadian stock market holidays; use Dividend Reinvestment Programs (DRIPs) in tax-advantaged accounts but not in non-registered accounts; stick to Canadian-domiciled ETFs for simplicity’s sake.
Step 8. Keep it in balance
This chapter is all about rebalancing, something that you will need to do periodically. Actually, you may not need to rebalance at all if you elect to buy one of the all-in-one ETFs that were pioneered in Canada by Vanguard and have now been adapted by BlackRock’s iShares, BMO, and other ETF providers.
If you own multiple ETFs, however, then rebalancing will be necessary. There are three basic approaches to rebalancing. One is to do so at the same time every year. The second approach is to rebalance when a certain percentage threshold or guardrail has been breached. For example, if your threshold is 5% and your target allocation for your bond ETF is 40% if it drifts down to only 35% of your portfolio, then you rebalance. A third approach is to rebalance using contributions. In that case, you contribute the most to the security that is the poorest performer. This is ideal in non-registered accounts since it does not require you to sell (and realize a capital gain on) a portion of the asset that has appreciated higher in order to fund the lower-return asset. However, be cautious about doing this in multiple lesser amounts if your broker charges commissions.
Step 9. Stay the course
Despite the evidence from academic research that most DIY investors will have more successful outcomes if they stick with simply structured index-tracking portfolios, financial media, professionals in the industry, and your neighbour who bought Tesla at $90/share two years ago will argue that you have made a huge mistake. Even worse, you will be your own worst enemy. Bortolotti closes off his book by addressing several behavioural biases that stand in the way of investing success with ETFs:
- Analysis paralysis
- Addiction to predictions
- The urge to pick stocks
- The urge to do something
- Fear of missing out
- Overestimating your risk tolerance
- Believing the industry’s BS
- Not giving it time to work, and
- Becoming an indexing zealot
To wrap it up, Reboot Your Portfolio is an excellent introduction for the DIYer to learn how to invest with ETFs. It goes well beyond the mere steps, though, to include a foundation for the choices that Bortolotti recommends. There is no appeal to his own authority. Rather, he cites research – and provides helpful illustrations – to justify his recommendations. He is also humble enough to recognize that zealotry in defence of indexing (Point 9, above) is, more often than not, counterproductive. Originally, issued as a paperback, it is now available as an e-book, too. If you don’t need it yourself, consider buying it for someone who is struggling with investing. They will thank you.
And with this post, welcome to 2022. I wish you all the best in your financial planning endeavours. Let me know if I can be of assistance by contacting me through any of the channels below.
This is the 129th blog post for Russ Writes, first published on 2022-01-03.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.