Investment Costs Matter

June 30th, 2008 · No Comments · Subscribe to this feed

Last week, I wrote that from a modern portfolio theory perspective, stocks actually become more risky with time (Obi-Wan Kenobi was right). Because even small differences in returns can have monumental consequences to the eventual size of your nest egg, every little bit counts. Mutual funds with high expense ratios are an unnecessary and outright harmful drag on returns.

The main reason I like index funds is their rock-bottom expense ratios. Low expenses means you keep more of your investment returns to compound for you over the years. A cost drag of just 1% (about average for an actively-managed fund vs a low-cost index fund) can amount to a nearly 50% hit to your next egg over 40 years. That’s huge.

A Reliable Predictor Of Future Returns

In an attempt to isolate factors most likely to lead to superior portfolio returns, a 2002 study by the Financial Research Corporation analyzed 10 potential predictors of future performance. The conclusion? Low expenses are the one and only reliable predictor of future success. That is, mutual funds with low expense ratios tended to have above-average returns relative to their peers while funds with high expenses tended to have below-average returns. Statistics such as Morningstar ratings, alpha, beta, and manager tenure all had dubious value in predicting future winners. The solution? Allocate at least 80-90% of your portfolio to low-cost index funds. If you insist on trying to beat the market, limit this to a small percentage of your overall wealth.

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