Why Do Investment Expenses Matter?
As investors, much of investing is out of our control. We cannot predict what the stock or bond markets will return in the future. We cannot accurately chart the path of future interest rates. In fact, almost every investment decision is made under varying degrees of uncertainty. However, there is one area of investing that directly impacts our investment returns and is 100% in our control: the fees we pay for investment products and services.
In most other areas of our lives as consumers, most think of the prices we pay for things with a simple paradigm. We pay more for things we believe have more value. The higher-priced shirt should last longer and hold its color better. The higher-priced watch should hold time better, or at least be more appealing to us visually. However, as we shift from being a consumer to being an investor, this paradigm of paying a higher price for something that is more valuable to us is inverted.
Holding all else equal, higher expenses means lower returns. You can see that simple equation spread out over an investing lifetime below.
Now, most investors at this point are likely thinking, "wait, you are completely ignoring returns, shouldn't a higher-priced investment return more?"
At BrightScope we do believe that good money managers can add incremental return above their benchmarks. While not all academic research agrees, we see value in the security selection services that these top managers provide. Unfortunately for investors, on average, mutual fund managers underperform.
But, how can these two ideas - top fund managers add value, as a group they do not - make sense, when they are seemingly in conflict? The answer: investment expenses. Fund managers can add value through security selection, before their fees. And across the entire mutual fund marketplace mutual fund managers charge more in fees than they deliver in value, so the end result is mutual fund underperformance.
The real problem for investors is that it is exceedingly hard to identify top managers in advance of their outperformance. For most investors, trying to outperform is a bad strategy. The better strategy is controlling expenses as much as possible.
When evaluating mutual funds in particular, and whether you are believer in active or passive management, we recommend selecting funds that have expense ratios that are lower than the average fees in their category. The general rule if you are relatively new to investing or are more passive in mindset is the lower you go the better. You will beat a lot of investors following that simple rule, particularly when you are saving in your retirement plan over a long time horizon.
So look at BrightScope's fund scorecard and find funds that are Low or Lowest fees. Those funds look like this: