Costs Matter If You Want to Maximize Investment Returns

Today is my day to host AllFinancialMatters' Bogleheads October project where a different personal finance blog reviews a chapter of The Bogleheads' Guide to Investing every day. Today I'll be summarizing and commenting on Chapter 9 - "Costs Matter."

I'll start in the reverse order of how I usually do a review -- with my comments on this chapter. I was one of the first to sign up for this writing project and as such, I got my pick of the chapters. Since I'm a big believer in keeping costs low (for my thoughts on the issue, see How High Mutual Fund Fees Can Cost You Millions (Another Reason You Should Love Index Funds)), this chapter was a natural fit. And as I expected, I absolutely loved this chapter (as well as the entire book -- I'll be reviewing it in total at the start of November.) It fits my personal thoughts on the issue of investing and costs exactly. In fact, if I could write a book on investing, this would be it. And if I wrote a chapter on costs and investing, chapter 9 of The Bogleheads' Guide to Investing would be it!

The chapter title highlights a quote from Jack Bogle, the founder of Vanguard:

The shortest route to top quartile performance is to be in the bottom quartile of expenses.

Then, the chapter begins with a paragraph that summarizes the pages to follow:

We are accustomed to believing that the more we pay for something, the more we receive. Sorry; this is not how it works when buying mutual funds. Every dollar we pay in commissions, fees, expenses, and so on is one dollar less that we receive from our investment. For this reason, it's critical that we keep our investment costs as low as possible.

Look at it this way, would you rather have an investment that returns 12% but has expenses of 2% or one that returns 11% but has expenses of 0.5%? It may not seem like that big of a difference, but that extra 0.5%, when compounded throughout the years, can make a big difference in your total return. But that's making an assumption -- that mutual funds with higher expenses ratios perform better. This isn't always (or even usually) true. So which would you rather have -- an investment with a 12% return and 2% expenses or one with a 12% return and 0.5% expenses? But I'm getting ahead of myself. We'll talk more about this later.

The chapter continues by telling just how much of investors returns are eaten up by fees every year -- about $300 billion. Yes, that's billion with a "b." Yikes! If we could save just a portion of that as investors, imagine how much more money would be in our pockets (instead of the pockets of advisors, brokers, large investment companies, and the like.)

Don't think that there are really that many costs associated with mutual funds? Think again. Here's the list (covered in detail in this chapter) of potential costs associated with mutual funds as listed in The Bogleheads' Guide to Investing:

• Sales charges on purchases (load funds)
• Deferred sales charges (load funds)
• Purchase fees
• Exchange fees
• Account fees
• Redemption fees
• Management fees
• 12b-1 fees
• Other operating expenses
• Hidden transaction costs
• Brokerage commissions
• Soft-dollar arrangements
• Spread costs
• Market impact costs
• Turnover
• Wrap fees

These are just costs associated with buying, holding and selling mutual funds. This chapter doesn't even cover another huge expense -- taxes (that's for the next two chapters).

So, how much do average fees cut into your return? Here's a list of the average equity mutual fund and what percentage of assets each of these fees takes out of the investment:

• Advisory fees 1.1%
• Other operating expenses 0.5%
• Total expense ratio 1.6%

• Transaction costs 0.7%
• Opportunity cost 0.4%
• Sales charges 0.6%

• Total Annual Cost 3.3%

How bad is this 3.3%? It's HUGE! The book gives an example of a guy who saves $3,500 annually in a Roth IRA from 25 to age 65. If his investments return 10.4%, he ends up with $1,727,501. If his investments return 7.1% (10.4% less the 3.3% costs), he ends up with $716,916 -- almost 60% less!

The book goes on to site studies that have shown how low costs equate to solid returns:

• The Financial Research Corporation found that the expense ratio is the only reliable predictor of future mutual fund performance.

• Standard and Poor's reported that in eight out of nine categories, lower-cost funds beat higher-cost funds during 1-year, 3-year, 5-year, and 10-year periods.

So, what should we do? Here's what the book suggests:

Knowing the tremendous advantage of keeping costs low, we need to put this knowledge to good use. Whenever possible, we will use index funds with their low cost and low turnover. ETFs and low cost, low-turnover, managed funds may also be considered.

Now you can see why I like this chapter so much. And it's another good reason why I like index funds. ;-)

Comments

[JLP at AllFinancialMatters]

Great job! Thanks for reviewing a chapter.

I kind of figured that you would like the book.

[Taylor Larimore]

Hi FMF:
Thank you for your positive review of Chapter 9, "Costs Matter," in our "Bogleheads' Guide to Investing."

You might be interested to know how surprised we were, while doing research for this chapter, to learn the large number of mutual fund fees (disclosed & hidden) that you listed, above.

You are to be commended for emphasizing the advantages of index funds and the importance of keeping costs low.

Best wishes.

Taylor Larimore
Miami, Florida