Charlie Munger coined the term lollapalooza to describe an extreme outcome resulting from several powerful forces acting in the same direction. Stated another way, a lollapalooza is when 1 + 1 + 1 = 5. As related to investments, lollapalooza’s are usually only found through expert understanding of a particular business or market. However, there is one lollapalooza that is available to even the most novice investors: index funds + retirement accounts + dollar cost averaging.
There are at least three powerful forces at play here, that combined over a long period of time can create significant wealth. [1]
Broad-market stock index funds are an ideal tool for the “know-nothing” or “know-little” investor as they allow for broad diversification across U.S. equities at extremely low cost; the typical U.S. Total Stock Market or S&P 500 index fund has an expense ratio of less than 0.1%, compared to 0.5% - 1.0% for the typical actively managed fund. Since active mutual funds as a group are almost guaranteed, by definition, to match the performance of the market as a whole, index fund investors as a group will outperform the active fund crowd by precisely the difference in fees. [2] Unless you have the skill to select an exceptional fund manager, and stick to just one or a small handful of funds, you will be better off with an index fund. [3] Thanks to compounding, these reduced expenses add up to large sums over time.
Adding in the typical 1% fee of a financial advisor creates an even starker contrast; an ending account balance for the index fund nearly twice that of the actively managed funds. [5]
Retirement accounts are under-appreciated and under-utilized. They provide fantastic tax advantages that add up to large savings over time. Until an investor has fully maxed out all available tax-sheltered retirement accounts - IRA, 401K, HSA, etc. - they would be foolish to invest in taxable brokerage accounts. [7]
As shown in the table below, a 25% increase in the post-tax 40-year account balance can be achieved through use of retirement accounts. [8]
In addition, employer-sponsored retirement plans such as 401K and 403B often offer contribution matches averaging around 6%. This is literally free money that your employer is offering every year as an incentive to prepare for retirement. Viewed another way, these matches provide an instant 100% return on investment - you won’t find that kind of return anywhere else!
Dollar cost averaging (DCA) is another widely-known but under-appreciated tool in the investor’s toolbox. DCA involves allocating a fixed amount of money on a weekly or monthly basis for the purchase of a given security. As the number of shares that can be bought for a fixed amount of money varies inversely with their price, DCA effectively leads to more shares being purchased when their price is low and fewer when they are expensive. This leads to a fair average cost per share over a period of time without determination of a fair price on the investor’s part; DCA allows the “know-nothing” or “know-little” investor to participate in the stock market without risking paying exorbitant prices.
DCA is even more powerful than stated above; not only does DCA provide the investor with a fair price, it actually provides the investor with a bargain price. Take a look at the chart below showing a purely theoretical security that simply fluctuates in a sawtooth pattern around a mean value.
The above asset has an average value of $150 per share. What would happen if you dollar cost averaged into this security that never appreciates in value? Let’s pretend you made two DCA purchases of $200, one at the peak price of $200 per share and one at the minimum price of $100 per share. The first purchase at $200 per share buys 1 share, and the second purchase at $100 per share buys 2 shares, resulting in 3 shares owned in total. The average price paid for the shares is $400 / 3 shares, or $133.33 per share - that’s not only a fair price, its actually less than the average price of the shares over this time period! If you sold these shares at the average price of $150 per share you would gross $450, a $50 profit. [9]
Applying this happy phenomenon to the purchase of an asset that is likely to increase in value over the long term in addition to fluctuating in the short term (e.g. S&P 500 Index Fund) leads to solid returns despite an investor's inability to assign a fair value to the underlying asset. [10]
The two plots below show a possible future trajectory for the U.S. stock market over the next 40 years of 6% annual growth along with corresponding results an investor would achieve maxing out contributions to Roth retirement accounts over this period using DCA, investing the entire sum in a corresponding stock market index fund.
The ending balance is $4.2 Million [13], a whopping 3.6X total contributions. That’s a pretty remarkable return considering it required almost zero knowledge or effort, and is entirely tax-free! [14]
[1] Compounding is another powerful force at play, and is arguably more important than the three described here, but it is generally well understood and I have little to contribute to the topic.
[2] All active investors as a group - mutual funds, pensions, individual investors, etc. - must match the performance of the market as a whole by definition; beating the market is a zero-sum game.
[3] The more actively-managed funds you own, the closer you approach complete diversification across the market, in which case you effectively own a broad-market index fund but are paying higher fees for it.
[4] These numbers are not adjusted for inflation and therefore it is important to focus on the account balances for each approach relative to the other, as opposed to the absolute dollar amounts.
[5] This assumes all the advisor is doing is asset allocation. An advisor utilizing index funds while providing sound guidance on the tax side can provide great value so long as their fee is sized appropriately. Unfortunately, such advisors are few and far between, and you have to be a fairly savvy investor to identify one, in which case the benefits are reduced.
[6] This analysis leaves out the extra tax inefficiency of active funds due to their higher turnover ratios: an additional drag typically around 0.5%. However, this disadvantage can be negated by utilizing retirement accounts.
[7] By investing in the Roth variant of the IRA/401K you can withdraw the money you invest, not including dividends and capital gains, without penalty at any time negating most of the flexibility advantage of the non-retirement account.
[8] The actual advantage will depend on the individual investor’s tax brackets with the highest income investors receiving the largest benefit.
[9] The amount of return you would receive in such a scenario increases the greater the fluctuation in the price of the asset. Unrealistically large fluctuations were used in this simple example to quickly demonstrate the concept.
[10] This only works with a fairly efficient market, as an asset that stayed at an unreasonably high price for the duration of one’s working career only to plummet back to reality upon retirement could easily negate any benefit from using DCA to capitalize on small price swings in the short term. Luckily, the U.S. stock market is in general highly efficient.
[11] Assumes steady 6% return compounded annually with alternating 5-year bull and bear markets contributing an additional 1% monthly compounded increase/decrease respectively.
[12] Assumes $6K annual employer match and no expense ratio for index fund for simplicity. The 0% expense ratio only slightly overstates reality as the tiny expense ratio of 0.04% results in a maximum of $2500 expenses occurring during the year of peak account balance of over $6M.
[13] These numbers do not account for inflation, and therefore would be severely overstated in terms of buying power except for the fact that salaries and retirement contribution limits rise as well with inflation and were kept static for this analysis.
[14] Conservative assumptions were made for this analysis whenever possible. A 6% annual return for the U.S. stock market was used despite historical return for the S&P 500 closer to 10%. There is a compelling argument for future returns falling well below the 10% level due to a large component of past returns being due to speculative and unsustainable P/E ratio appreciation as opposed to sustainable increases in productivity of the underlying businesses. For the theoretical stock market index growth, rosier numbers would emerge if the trend started with a bear market instead of a bull market.
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