Costs Matter More Than You Think

Cern BasherBrilliant Insights

Wooden Blocks with the text: Fees

There are three simple time-tested rules in investing.  But, like a lot of things, they are in need of an update.  This is the second post in a three-part series.

The first post in this series discussed the importance of diversification.  Our Updated Rule #1 was: Diversify to the point of discomfort to control risk.

Now for Original Rule #2: Costs matter

This rule is straightforward.  The lower your costs, the greater your share of an investment’s return.  For example, when stocks produced double-digit returns, paying 1-2% for investment management services might have seemed reasonable.  But now that stocks are generally earning substantially less, it’s even more important to re-examine the fees you are paying your advisor.

In addition to your investment management fees, all investment funds have their own management fees.  Some are higher than others, and higher fees don’t always equate to better returns.  Research has consistently shown that lower-cost investments have outperformed their higher-cost alternatives. The more you pay in investment expenses, the less money you will have to keep.

So why do investors continue to overpay?  The biggest reason is they don’t realize how much a seemingly small difference in cost – say 0.50% per year – actually makes long-term.  Do the math yourself, or have someone show you how it would impact your portfolio.  You will quickly see how much costs matter, especially when compounded over long periods of time.

Updated Rule #2: Costs matter even more than you think

Once you really understand how much costs matter, there is no doubt you will be motivated to seek out an advisor who charges lower management fees and who builds your portfolio with lower-cost investment products.  For example, there are two types of investment funds, those that are “actively managed” (the manager tries to pick the highest performing stocks in an effort to outperform a stock market index), and those that are “passively managed” (the assets mirror a particular stock market index and they will therefore produce the same return as the index).

Traditionally, most investors have chosen actively managed investment funds in an effort to outperform the stock market. But think about it.  Collectively, all the investors in the world earn a return that is equal to the return on all the world’s investments less the costs of management.  Some of these investments will outperform the average, while others will underperform.  This is a mathematical fact.  Picking the winning funds has been proven to be almost impossible.

So, why try to pick the winners if it is almost impossible to do it? Rather than take that risk, and pay more fees to do it, it makes more sense to seek to match the return of the global markets.  The best way to do that is to invest in low cost, passively managed, index funds that directly track the global markets.

Key takeaway: Investing in higher-cost, actively managed funds and counting on them to outperform is misguided.  It’s better to track the global markets with low cost, passively managed index funds.  Unlike the markets, investment costs are largely controllable, and it’s better to focus on controlling what you can.

Stay tuned for Updated Rule #3 – Invest like a kid in a candy store