Do you have an extra $186,000 lying around? If I told you you could have $186,000 more in your portfolio after 30 years by simply by reducing your investment expenses, would you be interested? I would!
When it comes to investing, fees matter. Whether you invest with an advisor, do-it-yourself or invest exclusively in a company retirement plan, the fees you pay to invest your money directly affect how much you end up with over time. You should always be able to easily tell what you are paying to invest your money.
This article will explain some of the reasons why mutual fund fees matter to your bottom line.
Index Funds vs. Active Funds- what's the difference?
Let’s start with two hypothetical mutual funds. We will call them “Index Fund” and “Active Fund.” I will quickly describe how an index fund invests money vs. the way an actively managed fund manages money. An index fund typically holds the same stocks as the index for which it is named. So, if you buy an S&P 500 index fund that fund will generally own the 500 stocks in the S&P 500- in the same proportions as the index.
What do I mean by that? For example, if Apple stock makes up 3% of the S&P 500 then your S&P 500 index fund would also contain 3% Apple stock. I should note that there are other ways to build index funds (such as sampling) but that is beyond the scope of this post.
Where an Index fund is essentially saying “I cannot predict the market. Instead, I simply want to own the market as cheaply as possible,” the Active fund manager is saying “I can predict the market. I know what stock is going to go up, when to buy it and when to sell it. I know which stocks are going to go down and when. I can repeatedly outperform the market year after year.”
The truth about Active Management
In reality, over time the vast majority of actively managed funds perform worse than index funds on an after-tax, after-fee basis1. In other words, the taxes generated by the mutual fund buying and selling stocks plus the fee the manager charges (the “expense ratio”) to manage the fund may cause active funds to under-perform a standard index fund when you take those costs into account.
One reason I like index funds is because they tend to be an inexpensive way to access the stock market, especially when compared to an actively managed fund. Many index funds can be owned for less than 0.25% a year on the money you have invested in the fund. Active funds tend to cost 0.7- 1.25% (or higher) a year. Let’s make the math easy and say our Index Fund charges 0.25% and our actively managed fund (Active Fund) charges 1.25%:
Does a 1% Investment Fee Really Matter?
You might be thinking, a 1% difference in fees? That’s basically $0. How much difference can 1% really make? A lot, it turns out. Let’s say you invest $100,000 to start and earn 7.25% on your portfolio every year. If you pay 0.25% to invest your money in the Index fund you will net a 7% return. If you pay 1.25% to invest your money in the Active fund you will net a 6% return. That may not make a huge difference over just a couple of years, but over 30 years it really adds up. In fact, that's where the $186,000 comes in. The lower cost portfolio leaves you with $186,000 more after 30 years compared to the higher cost portfolio.
Let’s look at this another way.
Stay with me, I’m going to teach you a cool party trick.
(Full Disclosure: “cool” is relative. I don’t know what kind of parties you go to but no matter what, you are going to want to know this.)
The Rule of 72 is an easy way of quickly estimating how long your money will take to double if you earn a consistent return. Take your estimated annual return and divide it into 72. This will give you an estimate of how many years it will take for your investment to double.
How Long Will It Take To Double Your Money?
Pick any number as your estimated return- let’s say 9 because 9x8 was one of my favorite times tables growing up...too much sharing? If you earn 9% a year it will take you about 8 years to double your portfolio (72/9 = 8). Or put another way, if you want to double your portfolio in 8 years then you need to earn a 9% return. Now, we know that portfolios generally do not earn the same return every single year without variation. So remember, the Rule of 72 is just for estimating.
Now back to our example showing the effect of fund fees on your long-term portfolio growth. If you earn a 7% return every year your money will double in just over 10 years (technically 10.28 years). If you only earn 6% your money will take 12 years to double. That may not seem like a meaningful difference at first but it makes a big difference. That difference means if you start saving at age 26 and earn 7% annually, your money will double when you are 36 (and a few months), again at 46 (and a half), at age 56 (and three quarters) and then one more time right at age 67 when you retire. If you only earn 6% annually starting at age 26 your money will double at age 38, age 50 and then not again until age 72 a full 5 years later than the account earning just 1% more. That’s the difference between having $1.6 million at the start of retirement or just under $1.1 million.
That’s why investment fees matter.
Now that you know why investment fees matter, find out if your 401(k) plan is ripping you off.
1.https://personal.vanguard.com/pdf/s296.pdf at the top of page 11.
2. For further reading on the affect of fees you can visit this site: https://personal.vanguard.com/us/insights/investingtruths/investing-truth-about-cost