Contain Expenses to Increase Returns

January 18, 2011
Shirley M. Mueller, M.D.

Studies on managed mutual funds show that less than 20% regularly beat unmanaged benchmark indexes. So why pay money-management expenses that can average 1.5% to 2.0% for performance that rarely beats the benchmark? The easiest way to guarantee performance over the long-term is to keep your investment expenses contained.

Two young professionals, each age 30, had $100,000 in the bank. Both choose to invest. One took basic educational courses to learn how to invest on his own, while the other went to an investment manager. At age 60, though each had invested in equivalent funds, the investment-manager client had accumulated $661,437, while the self-directed investor had $951,837.

Why does the self-directed investor do so much better? This example assumes an 8% return on each account. The investment-manager fees are 1.5%, so the real return for his client is 6.5%. The self-directed investor has expenses of 0.2%, so his actual return is 7.8%.

Studies on managed mutual funds show that less than 20% regularly beat unmanaged benchmark indexes. Investment advisors cannot be expected to do better. Even great performing stocks, funds and managers revert to the mean over time (Warren Buffet being the well-known exception). Most would agree though that finding a Buffet clone would be like finding a needle in a haystack.

So why pay money-management expenses that can average 1.5% to 2.0% for performance that rarely beats the benchmark? Likewise, rather than trying to take an educated stab at what will and won’t do well in your portfolio, the most dependable way to make money in the market over time is to:

Be in the market consistently, appropriate to your risk tolerance and level of assets; and

• Invest in low-cost, index-tracking mutual funds or exchange traded funds (which trade like stocks but perform like index-tracking mutual funds).

Proper asset allocation is key -- historically asset allocation accounts for 90% of portfolio return. It is the appropriate distribution of various asset classes in a portfolio, such as large-cap and small-cap U.S. equities, international equity funds, bonds and cash. The appropriate asset allocation for you depends largely on your time horizon and your ability to tolerate risk. (Learn more about asset allocation here.)

As Warren Buffet once said: “I don't look to jump over 7-foot bars; I look around for 1-foot bars that I can step over.” Investment expenses would be one of those 1-foot bars.

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