A Simple Step That Pays Huge Dividends

 |  Includes: AMTD, ETFC
by: Income Surfer

Last week, I wrote an article about getting better returns on your investment by knowing your strengths and weaknesses. You can read that article by clicking HERE. Today, I'm going to share another way that you can easily improve your stock market returns. It will take a few minutes of extra work upfront, but down the road, it will lead to dramatically better returns for your stock and bond investments. What am I talking about? Simple, keep an eye on your portfolio's costs.

Some mutual fund families have been notorious for charging high fees for years. The hedge fund industry is even more expensive with their typical "2 and 20" fee structure. (The "2 and 20" fee structure means the fund's management charges 2% of assets under management, as well as 20% of any profit the fund makes, annually.) It doesn't take a genius to see how a fee structure like that gets very expensive in a hurry. I'm sure you'd be fine paying higher costs in exchange for amazing performance year after year, but the fact of the matter is, few funds beat their stock (or bond) index in a given year. Far fewer still, have consistently done so over time. For every "Warren Buffett" fund manager willing to invest your money, there are literally thousands of average or below-average managers that talk a good game but fail to deliver the goods. This has fueled the whole passive vs. active portfolio debate. Type something like "why mutual funds underperform index funds" into Google, and you'll see what I mean. Study after study will tell you that index funds outperform the vast majority of mutual funds.

Compounding the problem is the fact that once a fund manager has established an outstanding track record of index-beating performance, they attract more investor money, which in turn leads to reduced performance. Need proof that increased assets under management can quickly lead to reduced portfolio performance? Look no further than Warren Buffett, who famously complained that he could return 50% per year by investing only in common stocks, provided he was only investing $1,000,000. If one of the world's best investors is hampered by the amount of money he needs to deploy, you can rest assured that the mediocre fund managers with $500 million in assets under management aren't likely to shoot the lights out.

So all of this circles back around to costs… how they add up, and how to minimize their impact. I believe the two charts below, by Vanguard and Fortune Magazine respectively, pretty well indicate how badly those fees can erode your portfolio returns. The first is a graphic by The Vanguard Group, which shows that a 2.5% differential in costs between two portfolios would cost about half the hypothetical return over 40 years. This chart is designed to hit home the idea that index funds (either ETF or mutual) are the better option. I agree that index ETF and indexed mutual funds are a great option for investors who want to be "hands-off" with their investment portfolio.

vanguard fees

The second chart shows the differential return between three hypothetical funds which earn the same market return, but have different cost (1%, 2% and 3% annually). You can clearly see that over time, the cost drag of the fund adds up. It has been said that compounded (returns) are one of the most powerful forces in the universe. Well, I'm here to remind you that compounded costs are equally as powerful, and very detrimental to your portfolio.

Fortune Fees

So now that we've established that higher costs are bad, let's discuss what you can do about it. The most important thing is to be conscious of how much you're paying and investigate if you have lower-cost options available. Some of the worst offenders for high fees are 401(k)s. Quickly, a 401(k) is a retirement saving option through your employer in the U.S. There are a variety of different types of plans and investment options, but the point is they tend to have high fees. The last 401(k) I was in had very few options and charged annual fees from 1.5% to 2.5%. The index fund options had lower cost, within my 401K, so it was an easy decision for me to go with them instead of the few actively managed funds. The whole plan was quite ridiculous, because the company's CFO was an active investor like myself… and very much knew better. Anyway, I contributed enough to get the maximum employer match and did the rest of my investing elsewhere. I rolled my old 401(k) over into a Rollover IRA as soon as I left that firm, which offered me many more options and much lower costs. If you still have 401(k) accounts from your former employers, you may want to ask your financial professional about this option.

You may have more (and better) options when investing outside of your employer's account. If you are a "hands-off" investor and investing in low-cost index funds (ETFs or mutual funds), you have a variety of options available to you. I own a few low-cost Vanguard index ETFs. It is amazing how much more expensive some other ETFs are, even though they track the same index. In one case, a foreign fund I own cost 0.15% annually, versus 0.67% for a competitor which has virtually identical holdings. Unless I was a day trader who required dramatically higher liquidity, I see no reason to buy the more expensive option.

All of us investors out there who purchase individual stocks have to watch out for costs also. Most of us use a low-cost "discount" broker, like Fidelity, Vanguard, TD Ameritrade (NASDAQ:AMTD), Scottrade, E*TRADE (NASDAQ:ETFC), etc. Which is good, but we also have to watch our costs. Each trade (buying or selling) costs us something. Even if it's a low cost, it's still a cost that is hurting our portfolio returns. I am not suggesting that you hold a bad investment because of minimizing trading costs, in fact I'm not recommending you do anything with your portfolio. That's for you and your financial professional to decide. What I did want to mention is that I minimize my trading costs by trading less frequently and in larger blocks ($5000 blocks instead of $1000 blocks, for instance). This is not a big problem for our portfolio, because I am a very marginal trader. I would much rather find a good investment and hold it for years. Many brokers have made it even easier to minimize costs by offering to buy or sell some index ETFs without cost, provided your holding period is long enough.

Hopefully, I have impressed upon you the importance of minimizing your costs when investing. It can make a huge difference over a 20, 30, or 40-year time horizon. I also think it's important to mention that only you, and your financial (or tax) professional, know which game plan is right for you. Decide on an investing game plan and stick with it through the market's calm and stormy seas. You'll be glad you did!