Why Costs Matter When Investing

Whatever your long-term financial goals and tolerance for risk, it’s important to achieve the best returns possible from your investments. Many people are unaware of how much impact expenses can have on the growth of their long-term assets. That’s why you should pay careful attention to all the fees charged by the company you entrust with your savings and investments.

The average stock mutual fund has an annual expense ratio of 1.5%. These are made up of costs to pay the managers and staff to run the mutual fund as well as the administrative costs of reporting and communicating with investors.

Beyond the expense ratio, there are latent expenses that the average investor will not see in a prospectus. First are the commissions for stock trades, which is pretty straightforward. But there is also the difference in the bid and ask price of a stock transaction, commonly known as the spread. This occurs in most stocks trades, but is material in less liquid markets such as small cap stocks. According to a Wharton Financial Institutions research paper by Edelen and Kadlic in 1999, it was determined that commissions and the difference in the spreads erode .8% annually.

Then there is cash drag; the need to keep cash on hand to cover ongoing redemptions. According to a Vanguard study, this erodes .4% of return annually.

Finally, you have taxes. Investors like to focus on gross returns, but what you receive after taxes is really what you earn. According to a Vanguard study, taxes on average erode 1.6% of return annually.

When you add it all up, it comes to around 4.3% and this figure doesn’t even go into potentially paying a commission to a broker to buy a mutual funds that has a load. This illustrates how incredibly hard it is for an active mutual fund manager to beat the market over time.

But, while you may not be able to predict how your investments will perform, you can gauge how much of a bite costs will take out of your bottom-line returns. When you invest in a managed fund, high sales commissions, excessive management expenses, and other fees can significantly erode your investment value.

Consider the cost differences in the following 3 hypothetical funds.

This illustration assumes three different rates of return, 6%, 8% and 10% every year before reinvestment of income distributions and before other fees, or taxes, are taken into account.

Clearly the impact of fees is significant over the long term. Even a small entry fee of 0.5% and a management fee of 2% in Fund C at 8% provides you with $16,517 less return than if you had invested in Fund A.

The old adage “you get what you pay for” doesn’t apply to investing. There is no proven correlation between expenses and investment performance — only that higher expenses mean less of your money is working for you. So invest wisely and consider using no-load mutual funds