It’s the new year, and holiday indulgences are lying heavily on us. Do you feel the annual urge to shed the excess?
May I propose a focus other than your dimpled thighs or lower-belly pooch? Instead let’s all go on the much easier investment-costs diet.
Costs are the one of the few things you can control about your investments. As Vanguard says, “The lower your costs, the greater your share of an investment’s return.” And even more, mutual-fund-research powerhouse Morningstar shows that “Firms with low fees have a higher likelihood of above-average performance.”
What Costs Are There?
So, let’s assume you’ve been persuaded that low-cost investing is the way to go. (Man, I am GOOD.) Is there just one cost for you to reduce? Oh, silly silly you. Of course there’s not. It’s the finance industry! There are many ways to take your money.
Note: Many of the following costs are related to mutual funds and exchange-traded funds (which I use both personally and professionally and believe to be the best way to invest).
You should be able to find these costs listed explicitly. Makes it easy to know what the expenses are, but maybe not why they are and how you should handle them.
Fees associated with funds:
- Expense Ratio: This is probably the most well-known cost of investing in funds. For example, the Vanguard Target-Date Retirement Fund 2045 (a fund I commonly recommend for my younger clients) charges 0.16% per year. That means for every $10,000 you have in that fund, you pay Vanguard $16. In 2015, the average expense ratio for mutual funds was 0.61%, according to Morningstar. Some funds charge over 2% a year!
- Loads. You pay this fee when you buy a fund (“front-end” load) or sell a fund (“back-end” load or “deferred sales charge”). It’s a commission that goes straight into the fund salesperson’s pockets. If you invest $10,000 in a fund that charges a typical 5% front-end load, you’ll really only be investing $9500, having just spent $500 on that load.
- 12b-1 fees. This is a common expense, usually between 0.25% and 1% of your assets, and funds use the money to pay for their marketing and distribution costs. I don’t know about you, but I’d rather not pay for a company to advertise its own products. The same reason my mother refused to buy me shirts in 6th grade that had “Esprit!” emblazoned across the front. (Aaaaand, I believe that dates me to within about 2.5 years.)
- Purchase and redemption fees: You might incur a fee if you purchase or sell funds too frequently or too soon after buying them. The fees discourage frequent trading, which drives up costs for the custodian where you hold your money.
Fees you can incur no matter what specific investments you invest in:
- Account maintenance or service fees: Some custodians charge you money to open or maintain an account.
- Professional fees: If you pay a fee-only investment manager/financial advisor/what-have-you to manage your investments, you probably pay that person a percentage—typically 1% every year—of your assets they manage. (If you don’t use a fee-only advisor, you’re still paying for management…it’s just indirectly through commissions and the like).
You think it’s hard to keep track of all the costs I just listed above? How about the ones that aren’t listed anywhere? Even the experts have to make an educated guess as to the size and impact of these costs.
Fees associated with funds:
- Transaction costs. These are the costs associated with buying and selling stocks (or bonds) within a mutual fund. Experts not only have a hard time measuring it, they even have a hard time defining it. Estimates indicate this is a significant cost to the average mutual fund: this paper by passive-investing king and Vanguard founder Jack Bogle estimates a conservative 0.50% per year for actively managed mutual funds.
- Cash Drag (opportunity cost): If your mutual fund has 5% of its assets in cash, that is 5% of your money that has no chance of growing significantly in value (or really at all, at current interest rates…Go Janet Yellen!). That same paper estimates this cost at 0.15%.
Fees you can incur no matter what specific investments you invest in:
- Tax inefficiency: What you invest in, how often you trade, and which accounts you invest in can have a significant impact on how much tax you owe. The more often you trade, the more often your funds trade, and the less money you put in tax-advantaged accounts like 401(k)s and IRAs, the higher your tax bill is going to be.
- Dumb Behavior. Probably the biggest cost of all, this usually boils down to buying higher and selling low.
All Together Now
Add alllll these costs up, and you have…(plus 1 times 0.15%, carry the 4)… a big friggin’ bite out of your investments.
How Do I Lower All Those Costs?
I don’t want to be simplistic, but there is a single answer that would prudently lower most of those costs: index funds.
More exactly, inexpensive mutual funds or exchange-traded funds that track major indexes (I’m talking Total Stock Market or US Small Cap indexes, not an inverse triple-leveraged technology index). Not all index funds are inexpensive, so be wary.
- Expense Ratio: Simply buy low-cost funds. Kind of a “duh” answer. But as one of my financial planning heroes, Allan Roth, says, “Dare to be dull.” Funds don’t need to be index funds to be inexpensive; but they usually are. There’s no magic threshold above which funds are too expensive. Expense ratios should be under, say, 0.25%. If you invest in your company’s 401(k), you have less control, and I’m willing to go up to, say, 0.70% purely for the convenience and simplicity of saving into that account.
- Loads: Don’t buy load funds. Ever.
- 12b-1 fees: Don’t buy funds with these fees.
- Account maintenance or service fees: If you don’t have much to invest, maybe these are unavoidable. Look for a custodian that doesn’t charge the fees. Or ask a representative if the fee can be waived if you promise to contribute regularly to the account. Consolidate your accounts in one place; if you’re saving regularly, you’ll soon have a balance high enough to avoid these fees. This happens to align with my emphasis on Simplicity, Simplicity, Simplicity. If you have all your money invested under one roof, you’ll understand it more easily, it’ll be easier to manage, and therefore you’re more likely to actually do so.
- Transaction Costs: Buy funds that have low “turnover,” that is, they don’t buy and sell very often. Every time a funds buys or sell, they have to pay a commission. Index funds usually win this race hands down, though there are some more-conservative actively managed funds that have low turnover, too. The popular Vanguard S&P 500 index fund‘s annual turnover is 3%, meaning it sells just 3% of its holdings each year. Contrast that to this fund, which has a 769% turnover, meaning it sells and replaces all of its holdings over 7 times each year.
- Cash Drag: Buy index funds. These usually have little to no cash, so all of your money is invested in securities that have a chance of growing. If you want cash in your portfolio (and there are good reasons for a cash cushion), then it shouldn’t be in your investment portfolio. It should be in your bank account.
- Tax inefficiency: The simple approach is to buy tax-efficient funds (index funds are; but so are some actively managed funds), put as much money as reasonable into tax-advantaged accounts like IRAs and 401(k)s, and don’t trade frequently in your taxable account.
There are a few, important fees that index funds won’t help you with:
- Purchase and Redemption fees: Don’t trade frequently. It turns out that frequent trading not only runs up costs for the company handling the mutual fund, but it also worsens your returns. Perhaps a rare occurrence where your interests are aligned with that of the finance industry’s!
- Professional fees: Evaluate what value you’re getting for your professional fees. They are possibly entirely worthwhile. I’m a financial planner and I manage my clients’ investments, so clearly I think this arrangement is fair: you pay me money, I provide you a service. But it is a worthwhile consideration: what are you getting in return for the fee you’re paying your professional?
- Dumb Behavior: Oh boy… I daren’t get into this huge topic in this blog post. If you didn’t do anything else I recommend in this post but you did manage your behavior rationally, you’d be so much better off. Problem is, it’s harder than everything else combined. Good investor behavior requires planning, discipline, and accountability. If you want to learn more about how your own brain tries to sabotage your good investment intentions, take a look at any of the books listed here.
A lot of my solutions to reducing fees boil down to: Be aware of what fees are being charged and simply avoid them. It’s pretty easy to avoid the fees; the trick is knowing the they’re there in the first place.
Can’t I Just Buy Stocks?
“But Meg, if I just owned individual stocks and bonds, I could avoid a lot of the costs associated with investing in funds.” And I say, “Right you are! But you’d buy yourself two significant risks that aren’t worth the cost savings”:
- Reduced diversification in your portfolio. Funds are a cheap way to own a lot of bonds or stock in a lot of companies. You’d be very hard pressed to own enough individual stocks and bonds to mimic the diversification of a fund.
- Increased complexity in managing your portfolio, which, let’s be honest, means you won’t do it as frequently or as well.
Unlike a diet to keep your trim, girlish figure, which requires daily attention and discipline, a diet to trim your investment costs is one that you can do once a year and ignore the rest of the time. (In fact, please do ignore your investments the rest of the time!) Do you want the novel experience of actually fulfilling a new year’s resolution? The Investment Costs Diet is probably right for you.
Question: What cost of investing surprised you the most? You can leave a comment below.
Do you want someone who can help you invest in a low-cost, tax-efficient, simple manner, so you can not only keep more of your returns for yourself, but also understand how and why you’re invested? Reach out to me at firstname.lastname@example.org or schedule a free 30-minute consultation.
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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner and/or an accountant for advice specific to your situation. Reproduction of this material is prohibited without written permission from Meg Bartelt, and all rights are reserved. Read the full Disclaimer.