There is an old joke in the world of stockbrokers
The biggest yachts in the marina don’t belong to the clients.
Your gains – profits – in mutual funds can be eaten up by management costs. Which is great for the fund managers and the Wall St. firms that they work for, but lousy for you.
In this article, I’ll show you how the costs of mutual funds can significantly reduce your retirement investments, what you need to look out for, and how to keep more of your money.
What is an actively managed fund?
An actively managed fund has a manager that tries to buy, sell and hold stocks in the hope of beating the market.
What is ‘the market’?
The market as you will hear time and time again, is how the stock market has performed over time.
On average the market has returned investors about 10% each year over the past 70 years.
When you hear someone say the market what they mean is:
Is this stock doing better, the same, or worse than returning 10% a year.
But you’re not getting the full picture
The market as I said has been measured for 70 years to get that 10% average. Most mutual funds, when you read about them, will tell you their performance over the past 1, 3, 5, or ten years.
How much money did you make last year? And the year before that? And the year before that? What’s the average for the past three years?
Ok, how much money did you make when you were ten years old?
Nine years old?
Eight years old?
You see when you consider your average income for the past three years, it has absolutely no relation to what your average income is since you were born, does it?
No, because if you didn’t start working until you were fifteen, the average would be a massive amount less.
Which is why when you look at the performance of a mutual fund, what’s it’s done lately doesn’t matter. It doesn’t matter like it does with the market. The market has a proven 70-year track record.
Most mutual funds don’t even have a 20-year history, let alone 70.
It’s why when you look at mutual funds the usually only include, 1, 3, 5, and ten-year averages. Because they look a lot better that way!
When it comes to mutual funds past performance is not an indicator of future gains. If you see a mutual fund that returned 25% in the last year, who cares?
It’s unlikely to repeat and only represents a burst in time.
Over time, 80% of mutual funds will fail to return even 10%.
What is the real price you pay for a mutual fund?
Fees vary in mutual funds, but it usually costs around 1.5% per year to own a fund. You’ll see averages stated as 1.5%, or some places will quote as high as 3%.
There are a lot of hidden fees that the unsuspecting investor simply doesn’t know about. And if you don’t know about them, you won’t know to ask about them. Chances are someone selling you a mutual fund isn’t going to explain them all to you either (they may not even know themselves).
The costs also vary if you have a non-taxable (IRA, Roth IRA) vs. a taxable account (traditional brokerage).
If you would like a more technical explanation, there is a great article at Forbes (warning – brain confusion!) detailing the six different costs associated with mutual funds. I don’t want to overwhelm you with facts, but I do want to provide links to the studies were done that prove what I’m telling you. Otherwise, I’m just giving out opinions.
Why you can’t afford mutual funds
You can’t afford to pay fund managers that don’t beat the market by at least 1.5% every year.
Hold up – that’s not beating the market by 1.5%, that’s just beating the market.
Meaning that 80% of fund managers don’t even make 10% a year on average.
Oops. Hope you’re not in one of those funds.
You don’t think 1.5% sounds like much? It represents 20% of the average market return over the past 70 years.
What is 1.5% worth?
Let’s say you invest $250 a month for the next 30 years, and earn a 10% return. Your investment would become $565,121.
Now consider an actively managed mutual funds with costs of 1.5% per year. Your return would only be 8.5%, not 10%.
What does that do to your investment?
You would get $412,676, or nearly $150,000 less.
That’s a big chunk of change!
Try it for yourself
Bankrate.com has a simple investment fee calculator you can use to compare different investment rates. I love simple.
You can plug in your starting investment amount, your additional contributions, how long you plan on saving, and then compare different investment rates side by side. It will be a real eye-opener for you.
I did a real simple calculation starting with $1,000 and adding $100 per month for 30 years. I chose to compare savings rates of 8%, 9%, and 10%.
At each rate, the total contribution is $37,000 over the 30 years. But the person who earns a 10% return and keeps it all ends up with $255,377.
The person who earns a 10% return but the fund management company gets paid 2% earns $151,824.
A rate of 10% earns $73,553.66 more than 8%. That’s a huge amount when you consider the investment only grew to $151,824.
How much over your lifetime?
Listen to me carefully – and don’t miss this:
There is a reason I don’t like actively managed mutual funds – they will bleed your retirement dry.
Do you have a choice?
If you participate in a company 401(k) probably not. Your 401(k) will have a limited selection (usually 12–15) of mutual funds.
Most of your choices in your 401(k) will have much higher costs than you could find if you bought funds on your own.
But everywhere else you invest – Roth IRA, IRA, SEP, traditional brokerage account – you can pick and choose the funds you want. Sweet!
What you should look for instead
Smart, savvy investors (or boring as I like to call them) invest in funds that try to be the market, not beat the market.
Why? As I said, 80% of actively managed funds can’t beat the market. It’s much easier to be the market and earn a respectable 10% a year than to try to beat the market.
And you will still build a huge pile of wealth to do whatever you want.
Be the market
In 1975, John Bogle realized what I just told you – most mutual fund managers are failing to beat the market. He founded Vanguard and introduced the world to index funds. Funds that try to be the market, and match the market rate of return.
You can own the entire stock market in an index fund that has a tiny cost of 0.17% per year. Compare that to 1.5% of most mutual funds – which are ten times more in costs!
For example, the Vanguard index fund that matches the S&P 500 uses a computer to include all the same stocks that are in the S&P 500, and in the same ratios as each company in the S&P 500.
Ok wait, what is the S&P 500? A simple definition is it’s a list of 500 big companies in the U.S. that represent a cross-section of industries – telecom, technology, healthcare, industrial, consumer goods, etc. By looking at these 500 companies, we get a benchmark to compare.
By using computers to mimic a market segment, Vanguard doesn’t need active managers and funds with huge costs.
When you buy the Vanguard index fund that matches the S&P 500, you’re buying tiny pieces of 500 different U.S. companies. It’s much cheaper (and simpler) than buying 500 individual stocks from each company, right?
Vanguard was modeled after credit unions that have low fees and build wealth for their clients. Today Vanguard has 20 million clients and the lowest management costs around.
What to do next
I’ve created a simple guide to help get you started investing. It includes simple, understandable investments that will earn the market average.
No fluff. No filler. No big fees.
Maximum return at the lowest cost.
Question: What are the costs of your mutual funds and are they beating the market? Please leave a comment below.