Warren Buffett has famously said that the number one rule of investing is ‘never lose money.’ Rule number two is ‘never forget rule number one.’ Now before you roll your eyes at the advice of arguably the most influential investor of our time, let's think about the application of this simple yet overlooked principle. Obviously, it applies to investment choices; don't pick losing positions. But it also applies to the fees and ancillary costs associated with otherwise smart investments.
There are transaction, advisory, and product costs with virtually every type of investment. At the very least, you have to pay a broker to execute a trade on your behalf. But people rarely take time to analyze the collective effects of these fees on their portfolio performance. Many times the same service, product, or investment can carry a different cost depending on where you get it. And over the span of your working years, the effects on your portfolio can be dramatic.
See if this gets your attention
It is easy to dismiss investment costs at first glance. ETF fees range from about 0.1% to 1.25% per year, and mutual funds range from 0.1%-3%. So when comparing them to say a plaintiff attorney taking 33% of a client's settlement, they seem relatively modest. However, do not fall for this deception.
The fees appear to fall within a constrained range, but if you do the math 1.25% is several multiples of 0.1%, meaning the effects on you investments can be staggering over an extended period. For example, if you invest $5,500 per year (the 2015 individual maximum IRA contribution) in an ETF with a 1.25% expense ratio and an assumed 6% growth rate over 30 years, you will have about $350,000. But if you had just invested that same money in a similar ETF with an industry average expense ratio of only 0.5%, you would have just under $400,000. That’s a $50,000 difference from simply choosing a more cost effective investment.
But what’s worse is that the effects are even more dramatic when applied to greater annual contributions. Individuals who are fortunate enough to work for a company that offers a 401(k) plan can contribute up to $18,000 (maximum for 2015). The cumulative difference between an account using low-fee investments versus high-fee investments for this level of annual contributions would be over a $150,000. That is incredible.
Where to look
Unfortunately, these fees are not always easy to find. You won't see them on monthly statements, and, unsurprisingly, they are not heavily advertised. However, every ETF and mutual fund has to issue a prospectus, which no one ever reads. But this information is summarized online through services like Moringstar and other fund research websites. There are several different terms used to describe these fees but most commonly they are listed as a percentage called the expense ratio or load. The expense ratio just divides the current or projected administrative expenses by the total fund assets, and the load is generally specific to mutual funds that may charge an additional fee upon their purchase or sale (front-end load or back-end load). There can also be transaction fees and commissions depending on the fund and broker.
The biggest names in low-cost investments are Vanguard and Fidelity. Both companies offer solid, passive investment products with low fees. Many other funds justify their high cost by active management that try to beat overall market trends. But the long-term investor is best served by finding low-cost funds that track market indexes.
If your custodian does not offer many low-cost investment options, IRAs are easy to rollover so that you can take advantage of better products. However, it can be more challenging with a company sponsored 401(k) since you are limited to the funds offered within the plan. But make sure you are at least invested in the most low-cost options available. Consult your financial advisor on specific investments.
I hope this information was at least illuminating, if not downright upsetting. Contemplating fees is not nearly as exciting as think about growth rates, but they are both important. Maximize your investment dollars by minimizing investment costs. That’s the best way to never lose money.