There are many things about investing that you can’t control: the boom and bust of the market, the impact of world events on your investments, interest rates, and more. But one important thing — that’s within your control — is what you pay for your investments.
Investment costs matter. In fact, investment researcher Morningstar has shown that in every asset class over every time period, the cheapest 25% of investments produced higher returns than the most expensive 25%. Low costs are a great predictor of performance.
Two common types of costs to look out for are the load, or the fees from buying the fund, and the expense ratio, which you continue to pay as long as you own the fund to cover the fund’s operating costs. You’ll want to consider optimizing both in order to get the best return over time.
Be Wary of Loaded Funds
Some mutual funds charge a substantial amount of money to buy into an investment. A loaded mutual fund charges a sales fee that’s often anywhere from 4-8% of the initial investment.
You can pay the sales commission when you buy (front-end load), or when you sell (back-end load). If you invested $1,000 into a front-load mutual fund with a load of 5%, only $950 would be deposited into your account, and $50 would go to the company as a commission.
No-load funds allow you to buy and sell the mutual fund shares at any time without a sales charge. These no-load funds might charge fees if you sell them early (usually within five years), but if you’re investing for the long haul, it’s nothing to worry about.
Loaded Funds Slow Down Growth
Let’s compare to returns for an investor who invests $1,000 a year for 30 years in the American Growth Fund of America (AGTHX), which has a front-end load of 5.75%, to that of one who invests in a Vanguard S&P 500 Index Fund (VFINX), a no-load fund.
This isn’t an endorsement of either fund. Keep in mind this is simply an example to help illustrate how costs impact returns. Let’s assume no expense ratio and that the investor makes a 10% return on both to make it simple.
You’d invest $942.50 per year in AGTHX, with $57.50 going to the advisor. The full $1,000 would be invested with VFINX. At the end of the 30 years, the AGHTX investment would be worth about $170,000, and the VFINX would be worth about $180,000.
That’s a difference of $10,000, just from the choice of investment. AGHTX is a managed fund, and the extra return is supposed to make up for the initial costs. But in many funds, the extra expense isn’t worth it.
It’s tough to earn enough extra return consistently over a long period of time. Why pay a load when you can find a comparable fund without it?
Expense Ratios Matter
The cost of buying and selling the investment matters, but often, expense ratios make an even larger difference. Remember, the expense ratio is a fee that’s taken off the entire investment balance every single year to cover operating costs for the fund.
Some types of investments cost more to manage than others, and the more expensive investments are necessary to have a diverse portfolio. For example, an international stock fund has an average expense ratio of 1.47%, while a US stock fund has an average ratio of 1.25%. But even when comparing similar funds, there’s a wide discrepancy in expense ratios.
Let’s see how a small difference in expense ratio can make a big difference. Take those same two funds we compared above, AGTHX and VFINX. AGTHX, the growth fund, has an expense ratio of 0.66%. VFINX has an expense ratio of 0.17%. Both are lower than the average expense ratio of the asset class, but Vanguard’s expense ratio is much lower.
If we once again invest $1,000 for 30 years with a 10% return (no load this time), how do the returns compare? At the end of 30 years, the expense ratio of 0.66% would end up with $159,000, and the one with the lower expense ratio of 0.17% would end up with about $175,000 — $16,000 more.
The difference in expense ratio might seem small, but over time, the difference in performance is huge. Expense ratios matter.
Cost Is Important, But It Isn’t Everything
Cost is a significant part of evaluating an investment purchase, but it isn’t everything. Not every low cost investment is worth buying — if the stock goes bust, you’re out all of your money. But when making investment decisions, consider the cost carefully.
