When the stock market can soar 30% in a year and individual stocks can quickly double, investment costs might seem like a minor issue. But the market doesn’t soar 30% every year, and most of your stocks, if they double in value, will likely take many years to do so.
Indeed, in a lower-returning market, costs can loom large. Suppose the stock market notches 6% a year. If you lose 1.5 percentage points to mutual fund expenses and other costs, you would be left with 4.5%. Trade frequently? You could surrender 25% of your annual gain to taxes, which means your 4.5% would become less than 3.4%. That might not seem so bad—unless inflation is running at 3%, in which case you’re making almost nothing.
You can’t do anything about inflation. But you can do your best to hold down investment costs and minimize taxes. Let’s say you bought a mutual fund that charges 0.5% in annual expenses and held it inside a Roth IRA. Even if the fund’s manager picks stocks that perform no better than the market, you would earn a 5.5% annual return, leaving you comfortably ahead of the 3% inflation rate.
It’s easy to overlook investment costs or dismiss them as a trifling matter. We sit up and take notice when we’re charged a $35 overdraft fee, but we might be oblivious to a fund’s 1% expense ratio—and yet that 1% would be costing us $1,000 a year if we have $100,000 invested. Moreover, fund expenses are stated as a percent of assets, rather than as a percent of our likely return. Paying 1% of assets might not seem so bad. Losing 17% of your potential 6% return sounds a whole lot worse.
Still, investors are increasingly aware of the damage done by high investment costs. A 2015 study by Chicago investment researcher Morningstar found that, over the prior decade, 95% of new investor dollars had flowed into mutual funds and exchange-traded funds with annual expenses that are among the lowest 20%.
So which costs should you watch out for? Try to keep a close eye on trading costs, fund annual expenses and the amount you pay for financial advice.
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