The Unforced Error
Paying High Fees
Worth It: Low-cost Index Fund
Not Worth It: Hot Mutual Fund
You probably keep tabs on your monthly expenses. But do you have any idea how much you're paying to invest? All those mutual funds in brokerage accounts and 401(k)’s come with a price tag—but it’s a price most people ignore. It’s called the “expense ratio,” and it generally varies from less than 0.1% to about 1.5%. Here’s a secret the financial industry doesn’t want you to know: The cheaper the fund, the better it is.
How great is that? With German cars and Swiss watches, you pay more to get more. You may consider Porsches overpriced, but would you rather be taking on the switchbacks of the Italian Alps in a Pontiac Aztek? With mutual funds, however, it’s the opposite. Stacks of academic studies have found that you’ll weather the twists and turns of the market better with a dirt-cheap index fund than with an actively managed high-priced fund run by stock pickers who try to beat the market.
Some guys spend hours analyzing mutual funds, certain that if they work hard enough, they’ll gain an edge. It’s a natural impulse—and it’s entirely wrong. There’s no more accurate predictor of a fund’s performance than its cost: The lower the cost, the better it’ll do. A study by Morningstar grouped funds into five categories, from most to least expensive. The cheap funds outperformed the most expensive ones 100% of the time. In short, you’re better off wagering that the Cubs will win the World Series than that your high-priced-fund manager will outperform the S&P 500 over the long term.
Here’s the math: The average stock mutual fund charges about 1.3%, or $13 for every $1,000 invested. Doesn’t sound like much, but compare that with a bargain-basement fund charging 0.7%, or $.70 for every $1,000. If at age 30 you invested $100,000 in the more expensive fund and earned 8% a year, at age 65 you’d have $935,258. Invest the same amount in the cheap fund at the same 8%, and at 65 you’d have $1,442,738. The difference would put six Porsche 911s in your garage.