Investing in low cost mutual funds versus regular or actively managed funds is one of the easiest ways to save a lot of money. I have written before about saving money the easy way by cutting back on recurring contractual expenses like bills and mortgage payments… mutual funds are no different. (Update: it turns out that you might be able to save even more money with ETFs.)
It is easy to forget that you actually have to pay mutual fund companies because the money comes out of your investment, not your checking account or credit card. Because most mutual funds charge roughly 1% of your investment per year, a seemingly trivial amount, it is tempting to shrug it off. But you shouldn’t shrug off, and here is why:
1. Low-cost indexed mutual funds perform the same or better than other funds. It is almost impossible to beat the stock market over the long-run. Actively managed funds are no exception to this rule, they just cost more because of more frequent trades, among other things. Even investment guru Warren Buffett failed to beat the market over the past 5 years.
2. Mutual funds are likely to be one of the biggest assets in your portfolio (probably THE biggest by retirement). So 1% of, say $500,000, is a ton of money to be giving away each year ($5,000 to be exact), especially when you aren’t getting better returns than other low-cost options.
3. You are losing even more in compounding growth opportunity costs. Because the fees are being withdrawn from your investment account, you are most definitely losing the potential growth on that money as well. So a $5,000 dollar fee will have turned into an opportunity cost of over $7,000 by year 10, not including inflation, and that is just the first year’s fee. Another way to think of this is that you would have to beat the market by over 1% in the long-run to simply break-even on the expenses, which we already know is pretty hard to do. And assuming, as I do in this example, that your investment grows at an inflation-adjusted 4% per year, a typical fund fee is eating away 25% of your total profit.
Hopefully those facts alone have convinced you, but I still have the ROI numbers to review below. Before that, let me define a few terms. What we are specifically talking about is the mutual fund expense ratio. An expense ratio of 1% means that 1% of the fund’s assets are required for things like salaries, marketing expenses, transaction fees, etc. It is the cost of doing business for a mutual fund, which is then passed on to you, the investor.
So how do some firms offer funds that have average expense ratios of only 0.2% while others have ratios over 3%? Generally, a higher expense ratio means more frequent trading. It could also just mean that a firm is just charging a little bit more or just more active in their marketing efforts. I tend to associate high expense ratios with boutique firms and niche funds that cater to wealthier clientele (“I pity the fool” – Mr. T)*.
Alright, now for the numbers. In this example, I assumed that you were maxing out your tax-advantaged retirement accounts, namely your 401k and IRA. The current contribution limits for those accounts are $17,500 and $5,500 respectively, for a combined $23,000 per year. So for someone making $50,000, this is about a 50% savings rate, and for a couple making double that, well, it would be closer to 25%. These are higher than American averages, but this time I wanted to cater to my target audience a bit. So here is how the cookie crumbles…
How much money can you save over 10 years by investing in low cost mutual funds??
- 10-Year NPV: $13,378
- 10-Year ROI: 468%
- 10-Year Payback: 0.2 years
This is literally a free $13,000 for someone who is investing in a normal, industry-average-cost, mutual fund. This is more than half a year of your annual savings regardless of what you make (half a year of work)! On top of that, this example is only for 10 years. Your savings will grow exponentially over a longer timeframe due to compounding interest (and of course you will be holding on to your retirement account for longer than 10 years). And finally, this assumes that you don’t have any existing balance. If you already have an existing balance, the savings will be multiples higher than $13,000.
You might have noticed that I added a new statistic on the bottom, “Annual Safe Withdrawal.” What this means is that after 10 years, the $13,000 savings will provide you a continuous annual stream of passive income to the tune of $500 per year or $40 per month. In real terms, that is a free gym membership for the rest of your life. All together, by year 10, your actual retirement savings in this example would be worth over $270,000 and throwing off safe withdrawals of $11,000 per year!
Regarding the expense ratios used in this example, I took them from Vanguard’s website. Vanguard is where I invest all my money because of the low fees and unique ownership model. Their average expense ratio is about 0.2%, and they pegged the industry at 1.1%, but I used 1.0% for a nice clean number. The reason Vanguard can keep their expenses so low is because they strive simply to track common stock indexes such as the S&P 500, so there isn’t a lot of trading required.
If you are lost about which funds to even start buying, Life Cycle funds are a really simple, one-stop solution. Just pick your estimated retirement date and start investing. If you want to get a little more involved, check out Personal Capital. They offer free net-worth tracking and portfolio management services. After you plug your information in, you can run the investment checkup tool, and they will tell you how to allocate your investments to maximize returns and minimize risk depending on your age and risk profile. For example, they will tell you to buy some combination of US stocks, international stocks, domestic and international bonds, and some alternative investments. You can then swing back to Vanguard and buy index funds that track these markets (just look at the holdings of a life-cycle fund to get an idea of the appropriate individual funds to buy, also alternatives are things like real estate investment trusts (REITs)). If you go the self-managed route, just make sure to rebalance every year or so according to what Personal Capital says your target allocation should be.
If you don’t know, now you know. Steer clear of anything but low-cost index funds and pocket AT LEAST an extra $13,000 every ten years (the savings will be much, much larger later on, closer to retirement). And if you have old 401k’s or IRA’s sitting around, think about rolling those over to lower-cost funds too (it is really easy).
- Inflation-adjusted growth of 4% per year
- Industry average fund expense ratio = 1% (Vanguard)
- Vanguard average fund expense ratio = 0.2% (Vanguard)
- Max out your 401k and IRA for total annual investment of $23,000
- No employer match factored in
- No prior investment balance
*Of course, we already know that most actively managed funds can’t beat the stock market. The exception is for funds that play outside of the stock market. Generally, these kinds of funds or investments are available only to the very wealthy. Think private equity or venture capital firms that invested in Facebook long before it went public. In these cases, it probably isn’t as foolish to pay higher fees, depending on the investment. But if you are paying high fees for publicly traded stock and bond mutual funds, I’m sure Mr. T would still have some choice words for you.