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Get to know your investment costs

All investments have costs. But how much you pay for your investments—and to whom—is up to you.

POINTS TO KNOW

  • Costs directly impact your investment returns.
  • Mutual funds, ETFs, stocks, bonds, and other investments each have different types of costs.

Remember … costs matter

Compounding is great when it's your returns that grow exponentially—but not so much when it's your costs. Make sure you understand how expenses will impact your returns.

Mutual fund costs

All mutual funds have:

Expense ratios. This expense is measured as a percentage of the amount you have invested—for example, 1.25%.

You won't see it on your statement; it's deducted from your returns before they get to you. So, for example, your mutual fund might return 5%—but if your expense ratio is 1%, you'll only see a 4% return, meaning you'll lose one-fifth of your return right off the bat.

The money from the mutual fund expense ratio goes directly to the fund to pay management and administrative costs, which could vary widely depending on the fund and company.

Many fund companies, including Vanguard, offer shares that allow you to pay a lower expense ratio if you make a large investment. Check to make sure you're paying the lowest costs you qualify for.

Some mutual funds also have:

Purchase & redemption fees. Mutual funds may charge a percentage of the transaction amount every time you buy or sell. (Redemption fees usually only apply for a certain time period—for example, if you sell shares you've owned for less than 2 months.)

These fees go back to the fund to offset trading costs.

Loads. Loads are similar to purchase and redemption fees in that they're charged when you buy (front-end load) and sell (back-end load) certain securities. However, loads are paid directly to the investment company, not the fund.

12b-1 fees. These fees are charged to pay for expenses to market and distribute the fund.

Commissions. These costs are charged when you buy or sell securities. They go directly to the broker through which you buy your fund shares.

ETF costs

All ETFs (exchange-traded funds) have:

Expense ratios. This expense is measured as a percentage of the amount you have invested—for example, 0.50%.

You won't see it on your statement; it's deducted from your returns before they get to you. So, for example, the investments in your ETF might return 5%—but if your expense ratio is 1%, you'll only see a 4% return, meaning you'll lose one-fifth of your return right off the bat.

The money from the ETF expense ratio goes to the investment company to pay management and administrative costs, which could vary widely depending on the ETF and company.

Bid-ask spreads. This is another cost you won't see. It's the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to receive.

For example, let's say you want to buy shares of a certain ETF and you bid $20 per share. As soon as your bid is the highest in the marketplace, a seller accepts your bid and the sale is completed.

But now that your offer has been accepted, the new "highest bid" waiting to be filled is $19.95. On paper, you've already lost $0.05 per share.

In practice, the bid-ask spread isn't only an indirect cost, it's also a good measure of liquidity. For very liquid ETFs—those with many buyers and sellers at any given moment—the spread will stay very narrow. For ETFs that don't trade frequently, the spread can be much wider.

Some ETFs also have:

Commissions. These costs are charged when you buy or sell securities, and they go directly to the broker. While all ETFs technically have a commission fee, you may avoid it by buying the ETF directly from the provider.

Individual stock costs

All stocks have:

Commissions. These are charged when you buy or sell stocks, and they go directly to the broker.

Bid-ask spreads. This is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to receive.

For example, let's say you want to buy shares of a certain stock and you bid $20 per share. As soon as your bid is the highest in the marketplace, a seller accepts your bid and the sale is completed.

But now that your offer has been accepted, the new "highest bid" waiting to be filled is $19.95. On paper, you've already lost $0.05 per share.

In practice, the bid-ask spread isn't only an indirect cost, it's also a good measure of liquidity. For very liquid stocks—those with many buyers and sellers at any given moment—the spread will stay very narrow. For stocks that don't trade frequently, the spread can be much wider.

Individual bond and CD costs

All bonds and CDs have:

Bid-ask spreads (price spreads). This is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to receive.

For example, let's say you buy a certain bond for $990. If the current bid price for that bond is $970, you've already lost $20 on paper.

A bond's bid-ask spread will be partly due to how liquid the bond is. Less liquid corporate and municipal bonds can have wider spreads because the pool of potential buyers is smaller.

Commissions. For bonds and CDs, commissions can vary depending on whether you're buying on the primary market or secondary market, and they may be levied based on the face value or per transaction.

Option costs

Commissions. For options, commissions are usually based on both a flat fee and a per-contract charge. An additional charge applies if you exercise the contract before expiration.

Bid-ask spreads. If you trade options (rather than either exercising them or letting them expire), you'll also be subject to a bid-ask spread, which is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to receive for the option.

In practice, the bid-ask spread isn't only an indirect cost, it's also a good measure of liquidity. Options that have a lot of potential buyers and sellers should have a narrow spread. Options that don't trade frequently can have much wider spreads.


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REFERENCE CONTENT

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Compounding

When earnings on invested money generate their own earnings. For example, if you invested $5,000 and earned 6% a year, in the first year you'd earn $300 ($5,000 x 0.06), in the second year you'd earn $318 ($5,300 x 0.06), in the third year you'd earn $337.08 ($5,618 x 0.06), and so on. Over longer periods of time, compounding becomes very powerful. In this example, you'd earn over $1,600 in the 30th year.

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Return

The profit you get from investing money. Over time, this profit is based mainly on the amount of risk associated with the investment. So, for example, less-risky investments like certificates of deposit (CDs) or savings accounts generally earn a low rate of return, and higher-risk investments like stocks generally earn a higher rate of return.

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Mutual fund

A type of investment that pools shareholder money and invests it in a variety of securities. Each investor owns shares of the fund and can buy or sell these shares at any time. Mutual funds are typically more diversified, low-cost, and convenient than investing in individual securities, and they're professionally managed.

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ETF (exchange-traded fund)

A type of investment with characteristics of both mutual funds and individual stocks. ETFs are professionally managed and typically diversified, like mutual funds, but they can be bought and sold at any point during the trading day using straightforward or sophisticated strategies.

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Share

A single unit of ownership in a mutual fund or an exchange-traded fund (ETF) or, for stocks, a corporation.

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Liquidity

A measure of how quickly and easily an investment can be sold at a fair price and converted to cash.

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Stock

Usually refers to common stock, which is an investment that represents part ownership in a corporation. Each share of stock is a proportional stake in the corporation's assets and profits.

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Bond

A bond represents a loan made to a corporation or government in exchange for regular interest payments. The bond issuer agrees to pay back the loan by a specific date. Bonds can be traded on the secondary market.

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Certificate of deposit (CD)

An insured, interest-bearing deposit that requires the depositor to keep the money invested for a specific period of time or face penalties. Brokered CDs can be traded on the secondary market.

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Primary market

A place where investments are initially offered to buyers. The primary market for stocks is an initial public offering (IPO). For bonds, purchasing on the primary market means you buy directly from the bond's issuer and pay face value.

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Secondary market

A place where investors buy and sell to each other (rather than buying directly from a security's issuer). Most stock and bond trading happens on the secondary market.

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Face value

The amount that the holder of a bond will be paid by the issuer at maturity, which can differ from the bond's value on the open market.

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Exercise

To act on the right established by an options contract. Contracts that aren't exercised will expire unused.