What follows is the final edition of my four-part look at active vs. passive. In it, I offer a broad how-to guide for the average retail investor. Including some timeless wisdom from the investment greats. This is not financial advice, but an outline of some basic concepts and ideas that may ignite your own due diligence.

 The Magic of Compounding

“I think the desire to get rich fast is pretty dangerous. My own system was to get rich slow… …if you get rich fast all you can do is be robbed by your own employees and your yacht and so forth. Whereas, if you get rich slow, you amuse yourself over a lifetime” – Charlie Munger.[1]

Meet Manu (a fictional character). Manu is a 25-year-old artisan from Melbourne, who one day inherits a generous sum of money from his great-aunt. Rather than splurge on a journey of self-discovery through South-East Asia, Manu decides to invest his $100,000 in an index fund. He selects a broad global equities index that’s averaged 7% annualised returns after fees. Assuming it sustains this performance, upon his retirement at age 65, Manu will be worth just shy of $1.5 million. Not a bad feat, given he exhibits no apparent skill for capital allocation! Of course, there are no guarantees in life (the average return over the next 40 years, may not be the same as the last 40 years). But it does highlight the impact of a very simple yet powerful economic force. One that Einstein dubbed “the eighth wonder of the world”. Compound interest. This phenomenon – the ability to earn interest on the interest – is what drives the snowball of wealth accumulation. It’s one of the most important ingredients for “getting rich slow”.

 [Opportunity] Costs of Speculation

“Rule No. 1: Never Lose Money. Rule No. 2: Never Forget Rule No. 1.” – Warren Buffett.[2]

One great investing misnomer is the idea that it’s okay to take big financial risks when you’re young, because you’ve got plenty of time to make up for any losses. This is a dangerous idea. To illustrate, let’s return to Manu. Now age 30, Manu’s colleagues are talking about something called “crypto currency”. Some claim to have doubled, tripled, even quadrupled their money in a matter of months. Growing restless with his frugal lifestyle – and watching his colleagues indulge on expensive cocktails with little umbrellas – Manu decides to invest in one of these “ICOs” himself. Not to be outdone, he boldly allocates his entire “winnings” from the index fund (about $40,000 by now) to the latest crypto-coin offering. Unfortunately for Manu, this particular issue turns out not to be the next Bitcoin. Instead, it falls victim to a group of Russian hackers who completely eviscerate his capital.

You might say that this isn’t a complete calamity for our hero, as he still has $100,000 invested and 35 working years ahead of him. But if we assume his remaining capital is left to compound at 7%, upon retirement, Manu will now only be worth $1.067 million. In other words, that brief but highly fraught $40,000 speculation actually cost him $440,000! The crucial point is that: the downside of any investment is not just the potential for immediate loss. It’s the opportunity to compound that capital over a long period of time.[3] And if there’s one resource you can’t get any more of, it’s time! Losing money dramatically sets back the tide of compound interest. And Manu’s story highlights how young people actually have the most to gain (and lose) from their investment decisions. The earlier we begin to accrue and invest capital, the greater the impact it has on our long-term wealth.

The Meaning of Average

Most people – by definition – are average. That’s not meant to be disparaging, it’s just a fact of life! And the world of investing is no different. The typical retail investor is endowed with average levels of skill, intelligence and knowledge of capital allocation. And it means that they are best suited to low-cost broadly diversified index funds (and ETFs), which promise average investment returns.[4] That doesn’t sound very exciting (it won’t make you the next Zuckerberg or Bill Gates), but as demonstrated by Manu, over the long run, “average” can do more than just secure your financial future. However, it’s important to remember that index funds are no financial panacea. Although they reduce the risk of under performing the market (as well as outperforming it) – and thereby protect investors from their own ignorance – it doesn’t mean you can “check out” entirely. Index funds are just a tool – or financial technology – for realising your economic ambitions. Still, the most important thing in investing is to think for yourself!

Planning with Index Funds

In the early years of indexing, investors were limited to a few indices, like the famed S&P 500. But today, they are confronted with all manner of asset classes, countries and industries. Trying to navigate these options can be overwhelming. As outlined in Are Index Funds Creating a Bubble?, many indices are so narrow that they actually lose much of their intended benefits. Even something as innocent as the S&P/ASX 300 index is not truly diversified, given that Australia makes up only 2-3% of the global equities landscape.[5] Betting on the economic fortune of a particular country or sector can be just as perilous as picking stocks outright. Instead, I believe the best option for any retail investor is to be as broadly diversified as possible, across a relevant selection of asset classes (that’s just my humble opinion). The most appropriate weighting of high and low risk assets (say equities vs. bonds) depends on your own investment time frame and income requirements. After that, wealth management becomes a matter of setting long term goals and personal financial planning.

 Risk & Dollar Cost Average

The biggest risk in using index funds has to do with timing. Let’s say Manu had invested his $100,000 in early 2007, right before the financial crisis. By 2009 his net worth would have almost halved. Moreover, his invetsment returns to date, would be less than the average return for that asset class. Such severe market downturns are always possible – even today. This timing challenge is known as market entry and exit risk. The only way for Manu to manage this risk is to spread his investment over a number of periods. This process of making regular and even contributions to a fund is known as “dollar cost averaging”. And it’s the most important element to succeeding as an index investor.  But there is no hard and fast rule. Manu could do monthly instalments over say 5 years, or even annual instalments over 10 years. Either way, the more time he takes to deploy his capital (and lower the risk of a poorly timed entry) the higher the opportunity cost. This is because a larger portion of his capital must remain on the sidelines for longer, and markets can always go up as well as down in the interim. In other words, any index investor not only has to manage the risk of losing money, but also manage the risk of missing out on opportunities. Balancing these factors again depends on your personal financial goals and individual appetite for risk. There is no ideal solution – only trade-offs.

The Virtue of Delayed Gratification

If you consistently spend less than you earn and invest it in index funds, [and] dollar cost average, because you’re putting money in every pay check; in 20, 30, or 40 years, you can’t help but be rich” – Charlie Munger.[6]

To wrap this all up, let’s now assume Manu’s great-aunt hadn’t been so generous. Instead, aged 25, he only has $10,000 to invest – which he saved through a series of part time jobs and birthday donations. Thankfully, he’s also managed to convince an unsuspecting local art gallery to hire him as a full-time curator. Just as before, Manu invests his $10,000 in a global equities index fund that’s averaged 7% returns after fees. But this time – after a stern lecture on materialism by his overbearing mother – he also decides to contribute $1,000 of his monthly income to the fund (each and every month). If Manu sticks to his contributions – and the fund sustains it’s 7% annualised return – then upon retirement, Manu will have amassed just over $2.5 million. That’s $1 million more than when he invested the large inheritance. By making regular contributions (dollar-cost averageing), Manu has not only reduced the risk of market timing, but dramatically increased his ultimate pool of wealth. This highlights another important but rarely appreciated fact of capital allocation: that investing and saving are two sides of the same coin. Building wealth is not about the occasional striking of riches. It is a slow and gradual process of accumulation. One that’s impossible without a penchant for frugality, prudence and delayed gratification. In the end, no matter how large or rapidly rising your income may be, if you do not have the discipline to spend less than you earn, you’ll never be wealthy.

[1] Charlie Munger, Q&A response at the 2015 Annual Meeting of Berkshire Hathaway Shareholders.

[2] Mary Buffett & David Clark, The Tao of Warren Buffett, 2006, pg. 13.

[3] This phenomenon is also known as the opportunity cost of capital. Namely, the benefit that a person could have received, but gave up, in order to take an alternative course of action.

[4] This includes the many high net worth individuals who inherit a large portion of their wealth.For example, consider a wealthy heiress from Toorak who opts to drive a Maserati convertible over say the humble Toyota Camry. So too, she may also decide to invest in a multi-strategy hedge fund, as opposed to a much less glamorous Vanguard S&P/ASX 300 index fund. The chosen fund manager may certainly manage to outperform the market, but the heiress has no capacity to determine, in advance, whether that will be the case. Although she might value the premium status of that service, the fact remains that she is ill-suited to such an active management approach

[5] See Australian Securities & Investment Commission: https://www.moneysmart.gov.au/investing/shares/international-shares#comparing.

[6] Steve Forbes, Transcript of Interview with Mohnish Pabrai re: Lessons from Buffett, April 2010, see https://www.forbes.com/2010/04/09/pabrai-leisure-china-intelligent-investing-technology.html