There’s one easy and reliable way to increase your investment returns, and you don’t have to be an expert to do it.
All you have to do is reduce the amount you pay for your investments. The lower your costs, the more likely you are to get better returns.
That may sound counterintuitive. We’re used to higher quality things costing more money, and it makes sense to think that you’d have to pay big bucks to access the expertise and superior performance of the best investment managers in the world.
You gotta spend money to make money, right?
Well, the opposite is true when it comes to investing. Both the research and the numbers back up the claim that the less you pay, the better your returns.
And the best part about all of this is that cost is one of the few investment variables that is directly within your control. You can’t predict what the markets are going to do, but you can absolutely control how much you pay in order to access them.
So in this article you’ll learn why investment costs are so important, how much of a difference they can make to your bottom line, and how to minimize the specific costs that can hurt you the most.
The predictive power of investment cost
In 2010, the investment research company Morningstar conducted a study to see which variable was better at predicting a mutual fund’s future return:
- Morningstar’s proprietary star rating system, which uses everything their experts know about a mutual fund to predict its future risk-adjusted return.
- The mutual fund’s cost.
What they found was that their star rating system was indeed a good predictor of success. Overall, a better star rating led to a better return 84% of the time.
But despite that excellent track record, they found that their star rating still couldn’t hold a candle to the simple exercise of looking at an investment’s cost.
In fact, the lower cost mutual funds in their study outperformed the higher cost mutual funds in 100% of the comparisons they ran.
Every single time, lower cost predicted better performance.
How much more money could you make?
Okay, so the research says that lower cost investments lead to better returns. But just how much of a difference does it actually make? After all, you might be comparing two investments with just a 1% difference in cost. Does that small different really matter?
Let’s run the numbers.
Let’s assume that you’re choosing between two mutual funds that invest in US stocks. Both are expected to earn a 7% annual return and you expect to contribute $5,000 per year for the next 30 years.
The only difference is that one fund charges you 0.15% per year and the other fund charges you 1.15% per year. Here’s how they stack up:
Over those 30 years, the lower cost fund would earn you an extra $83,708. That’s real money you’d have available to you simply because you chose a lower cost mutual fund. And if you’re contributing more than $5,000 each year, that difference would be even greater.
The bottom line is that even a small difference in fees adds up to a big difference in savings. Which means that it pays off to watch your investment costs closely.
6 big investment costs to watch out for
If you want to minimize your investment costs, and therefore maximize your investment returns, you need to know what to look for.
Here are some common investment costs you’ll want to minimize, along with a case study that shows you exactly how to find the cost of any particular investment.
1. Expense ratio
Every mutual fund has something called an expense ratio, which is a percentage of your money that’s taken out of your investment every single year to pay the costs of running the fund.
For example, let’s say a mutual fund has an expense ratio of 1% and you have $10,000 invested in that fund. That means that 1% of your investment is taken out of your account every year, which with a $10,000 investment would come to a $100 fee.
And because the fee is calculated as a percentage of the money you have invested, it grows over time as your account balance grows. You pay more and more each year simply because the market is growing your investment, even though the fund is performing the exact same job.
As we saw above, even a seemingly small difference in the expense ratio between funds can add up to a HUGE difference over time. Finding a fund with a lower expense ratio could earn you tens of thousands, or even hundreds of thousands, of dollars over your lifetime.
There are a lot of great mutual funds (mostly index funds) with expense ratios right around 0.20%, and often even less. If it were me, I’d have to have a REALLY good reason to pay much more than that.
2. 12b-1 fees
The 12b-1 fee is also expressed as a percentage of your total investment and is typically already included in the fund’s expense ratio.
But when you look at a mutual fund’s information you will see it displayed separately from the expense ratio because it’s not really a cost of running the fund. It’s a cost of promoting the fund, primarily paid to financial institutions who sell the fund. In other words, it’s essentially a commission.
While the existence of a 12b-1 fee shouldn’t automatically send you running, it’s a cost that should likely be avoided if possible. It doesn’t serve to help you — why should you care if the salesman gets a commission? — and it does take money out of your pocket year after year. And there are plenty of great funds that don’t include these fees.
A load is a commission paid to the person who sells you the mutual fund. The most common type of load is called a sales load, or front-end load, which takes a piece out of every single purchase you make in order to pay the salesman.
For example, a mutual fund might have a 5% sales load, in which case $50 out of every $1,000 you invest will be paid to a salesman instead of your account.
There are also back-end loads, sometimes called a contingent deferred sales load (who makes up these names?). This works the same way except that the charge is applied whenever you decide to sell your shares of the mutual fund.
There is plenty of evidence that you should NEVER purchase a mutual fund that includes any kind of load. They typically perform worse than similar mutual funds that don’t have a load, even BEFORE you factor in the extra cost. So in most cases that extra cost is essentially just money that the salesman is asking you to throw away.
4. Transaction costs
Transaction costs are the least transparent of all. These are the various costs incurred by the mutual fund whenever it makes trades.
Note that this is different than the cost you incur when YOU make trades. The mutual fund itself will buy and sell stocks or bonds or whatever it invests in, and those transactions have a cost. Different studies have found these costs to be anywhere from 0.1-2% per year, which can be a huge drag on your returns.
There’s no perfect way to understand a fund’s transaction costs, but the best way I know is to look at what’s called turnover. Turnover measures the percent of the mutual fund’s holdings that change in a given year. A turnover rate of 100% means that the fund changes all of its holdings during a given year.
You can find this information using a site like Morningstar or Yahoo! Finance (more on how to do this in the case study below). A higher turnover means the fund is making more trades, which means it’s more likely to have higher transaction costs.
As a point of reference, a good index fund like Vanguard’s Total Stock Market Fund (VTSMX) will have a turnover rate in the low single digits. That low turnover can do a lot to keep costs down.
If you’re investing within a retirement account like a 401(k), IRA or 403(b), then you don’t have to worry about this part of the conversation. Those types of accounts have tax preferences that make these points moot.
But if you have any money in a regular old taxable account, taxes can be another hidden cost that really hurts your returns. Here are some examples where taxes might come up:
- When a mutual fund makes a trade, there may be tax consequences.
- Interest earned from a mutual fund’s bonds will be taxable.
- Dividends earned from a mutual fund’s stocks are taxable.
- If you exchange one mutual fund for another, or if you withdraw money from your account, the transaction could be taxable.
All of these things will be treated differently based on the specific mutual fund and the specific investor but it’s worth paying attention to. After all, the more you pay in taxes, the less you’re able to use for yourself.
One simple but imprecise way to estimate the tax cost of a fund is to again look at turnover. In general, funds with a higher turnover will have a higher tax cost.
If you want to get more precise, Morningstar has a measurement called the tax cost ratio that can help you determine how tax-efficient a given fund is. I’ll show you how to find this in the case study below.
6. Trading fees
Depending on the company you open your accounts with and the specific investments you choose, there may be fees every time you buy or sell an investment. For example, E*Trade currently charges anywhere from $0-$19.99 every time you buy or sell a mutual fund, and $0-$6.95 every time you trade an ETF.
This can add up quickly, especially if you’re making regular contributions to multiple mutual funds each month. If you have automatic monthly contributions set up to 3 mutual funds, that could cost you almost $60 per month, or $720 per year.
There are usually some simple ways around this. I do all my investing with Vanguard and never pay a cent in trading fees because I only use Vanguard funds. Other companies like Schwab and Fidelity also offer fee-free trading of their own funds, and most brokerages have at least some funds that you can buy and sell without fees.
But it’s something you’ll want to watch out for, and, if possible, completely avoid.
Case study: Finding the cost of an investment
Figuring out how much a specific investment costs can be tricky, so let’s work through an example together.
The American Funds Growth Fund of America is one of the largest mutual funds in America. It invests primarily in stocks, though it can also invest in bonds and other instruments if it sees fit. As of this writing it has over $156 billion in assets.
So, let’s say that you’re considering investing in this fund and you’d like to know how much it’s going to cost you. How would you go about doing that?
First, look for the ticker symbol. The ticker symbol is a short string of letters that serves as a unique identifier for the mutual fund. When you Google “American Funds Growth Fund of America ticker symbol”, you’ll find that its ticker symbol is AGTHX.
Second, go to the website morningstar.com and enter the ticker symbol into the Quote field at the top of the page. That will bring you to a page with a lot of detailed information about the fund in question.
Third, review the various fees as they’re outlined on the page. Here’s a screenshot for this particular fund that points out where each fee is shown:
As you can see, this particular mutual fund has the following fees:
- Expense ratio = 0.66%
- Sales load = 5.75%
- Turnover = 31% (not a direct fee, but an indication of potential transaction costs)
Then, if you click over to the Tax tab, you can find the Tax Cost Ratio. As of this writing, the tax cost ratio for this fund ranges from 1.00% – 1.92% depending on the time period you’re looking at.
So, how does this stack up? Let’s compare it to a different mutual fund with a similar balance between stocks and bonds, Vanguard’s LifeStrategy Growth Fund (ticker symbol = VASGX).
According to Morningstar, here are the fees for that mutual fund:
- Expense ratio = 0.15%
- Sales load = 0%
- Turnover = 5%
- Tax cost ratio = 0.64% – 1.02%
Clearly, there’s a big difference in the fees charged by these mutual funds. The Vanguard fund is significantly less expensive across the board.
Now, this isn’t to say that the Vanguard fund would always be the better choice. Cost is just one part of the equation when making investment decisions.
But it’s important part of the equation, one that predicts future performance better than anything else, and now you have a process you can follow to compare the cost of similar investments.
Take the easy money
Reducing costs certainly isn’t the sexiest part of creating an investment plan, but it’s one of the most effective.
In fact, reducing your investment costs is the only proven way of increasing your odds of getting better returns. Nothing else works as well.
So do yourself a favor and keep a close eye on the fees you’re paying. Minimizing them will make it a whole lot easier to reach the goals you care about most.