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« 2010 | Main | Becoming Who We Are »
Saturday
Dec122009

Who Cares About One Percent?

As investors we spend a great deal of time searching for that just right investment, depending on whether we are saving for college, retirement, or some other goal. There are numerous publications and television programs that purport to give us advice to help us with these types of decisions.  On any particular day one can find several talking heads on CNBC sharing their investment advice, recommending all manner of stocks, Chinese ETFs, commodities, various stock mutual funds, etc., etc. What these experts spend little time analyzing however, (unless they are like John Bogle and Scott Burns) is the impact various fees and expenses associated with those investments have on their ultimate success. Those who have spent some time considering this phenomenon know that over a lifetime of investing the expenses associated with their investments can have a significant impact on how successful they eventually become.   John Bogle, of Vanguard fund fame, and Scott Burns, financial author and columnist for the Dallas Morning News, have long beat the drum for low cost, index funds.  In fact, John Bogle was very instrumental in bringing index mutual funds to the market when he was head of Vanguard Funds.  Perhaps an illustration of the impact that fees can have on investment results would be helpful.  

Let's take the example of two industrious brothers, both committed to saving and investing for their futures.  Both invest $200 per month in their favorite mutual funds, and they both average 8% returns per year over the course of thirty years.  The only difference in their investing experience is that one brother pays a .05% yearly expense charge, and the other brother is charged 1.5% per year.  How did their investments, which both averaged 8% per year, turn out?  The brother who was charged a .05% expense ratio found his investment had grown to $248,000; not a bad start on a retirement fund, is it?  The other brother, who invested just as much of his hard-earned money, and made the same 8% return, but who paid 1.5% in expenses, found that he had $207,300 after the same thirty year investment period.  The difference in the outcome of these two investment programs, nearly $41,000, is solely the results of a 1% difference in expenses charged by their fund management  company.  Perhaps it would pay all of us to care about 1% when we are talking about investment expenses.

Occasionally we hear pundits say that some funds are justified in charging higher expenses because they have historically had higher returns.  I might well agree with this assessment if someone will only show me a reliable way of determining where those higher returns might be found in the future.  I can show you where they were found in the past, but as every fund prospectus will tell you, "Past performance is no guarantee of future results."   In fact, what we often find is that yesterday's winning fund manager becomes tomorrow's laggard.  It is very hard for any fund manager to consistently out-perform their comparative index.  This is partly, perhaps even primarily, attributable to the fact that any managed fund begins the year running behind their index's return by whatever percent that is attributable to the difference in their expense ratio.  In the case of our two brothers above, one began each year already 1% behind his brother due to the difference in the expenses they were charged.  His fund had to make 1% to just reach even with his brother's fund, and he had to do it year after year for thirty years.  Of course, in our example that did not happen, and the result was that he ended up with $41,000 less in his account.

In truth, fund managers overall have had a hard time justifying their existence lately.  A recent study indicated that as late as 1990 only 14% of actively managed funds beat their bench marks.  More recently, an even lower percentage, less than 10%, of actively managed funds were able to beat their unmanaged index.  One can marvel at the fact that so many fund managers are able to convince so many investors to pay them so much money to accomplish so little for them.  The fact that a small percentage of active managers were able to return superior results for a few years, or several years for that matter, in no way guarantees that they will continue to be so successful.  I believe that a diversified portfolio of index funds and Exchange Traded Funds ETFs, with their low expense ratios, when held over the long haul, and added to regularly, will ultimately return more than their actively managed brothers.  

There are many things we cannot control in the investment world.  We cannot control the general economic climate; we cannot control when the recession begins or ends.  We cannot control what happens in Washington or in Tehran.  There are also a lot of things we cannot know about any investment we may make.  We cannot know what it will return in the future.  Sure, we can look at historical averages and make some educated guesses, but know we cannot.  The only thing we can know for sure about the future of a mutual fund investment is how much we will pay in expenses because the manager is required to disclose the expense ratio before we invest.  That we can be sure about.  We may not know how much we will pay in the future for bread or gasoline or health care, but we can know what the expense ratio will be for our mutual fund investment. We can control this expense to a certain degree because we have so many choices.  Yes, we have to pay something, even if we make our stock selections with a discount broker.  But we can choose to invest in low cost funds. Low cost funds have proven over time to be as good as, and usually a better investment, than the higher cost funds. When looking at the universe of funds, this is simply a fact. 

Over the course of my investment life I have used both index and managed funds, but my aim is always to pay less than 1% in expenses for my fund investments, unless it is a fund that invests primarily in foreign stocks.  Investing in foreign stocks is an inherently a more expensive proposition, and it is going to cost a bit more, but good foreign stock funds can be found that charge less than 1.5%.  Many good bond funds are available which charge less than .25%, thus I try never to pay more than that for a bond fund.  No, we cannot control everything, but we can do what we can and choosing low cost funds for our investments will pay off in the long run. It pays off because it leaves more money in our pockets instead of transferring it to the pockets of a mutual fund manager.  Unless you are a fund manager, that is a good deal for you.

 

Fly/Drive Safely

12 December 2009

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  • Response
    Retirementflightplans - Journal - Who Cares About One Percent?

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