Index funds offer a simple plan for retirement riches

Just two index funds and a once-a-year portfolio rebalancing can make you rich.

Everybody knows the mantra Buy Low, Sell High. But when stocks are on sale, most investors shun them. They freak out, sell stocks and stuff money into mattresses, tin cups…and bonds.Then, when stocks increase in price, investors stampede into the same stock products they previously shunned.

Take last year. When the world’s stock markets offered generously discounted prices, our American neighbours dumped stocks to buy bonds.

According to the NewYork–based firm, Strategic Insight, 2011 saw net redemptions of US$42.8 million from U.S. stock mutual funds, while investors added US$193.9 billion into bond funds.

The stock market deserters then stood on the sidelines as the S&P 500 rose 26% from last Sept. 30 to April 2. Canadian investors followed a similar pattern. And today, as mad as it sounds, North Americans are warming up to stock purchases once again now that prices have risen.

But while many investors area little bit crazy, you don’t have to be. You can ignore the folly of the masses, spend just 10 minutes a year on your investment decisions, and spank the returns of almost everyone you know—merely by sticking to a simple strategy: keep costs down, diversify and avoid the trap of buying high and selling low.

Building a portfolio of low-cost index funds ensures that you invest economically. To coverdiversification, meanwhile, you could buy a Canadian stock market index, a U.S. index and an international index. Then purchase a bond index that correlates roughly with your age. A 40-year-old investor, for example, might consider having 30% to 40% of her portfolio in bonds.

Once you build your portfolio, get ready to turn off the noise. Ignore the siren calls to “do something”and just rebalance it once a year, back to its original allocation. By default, when stocks have fallen, you’ll be selling someof your bond index to add to your stock indexes. When stocks have risen, you’ll be adding to your bond index and selling some of your stock indexes.

In September 1991, Scott Burns, writing for The Dallas Morning News, suggested the superiority of a similar method: a portfolio split evenly—and rebalanced annually—between a U.S. stock indexand a U.S. bond index. Burns called his method the “Couch Potato Portfolio.” Over the next 20 years, any U.S. investor following this strategy would have seen her portfolio gain 360%, compared to 346% for the S&P 500. A Canadian version—based on equal holdings of Canadian stock and bond indexes and a U.S. stock index, rebalanced annually—also did well. From 1982 to 2000, for example, when Canadian stocks surged 563%, this portfolio would have gained 885%. From 2001 to April 2012, it grew 55%, beating most stock and bond mutual funds.

It really is this easy. But if you take this route, understand that it’s a lonely one. Most investors (like lemmings) prefer the costly comfort of crowds.