Points to know
- All investments have costs.
- Money you lose to costs compounds (rises exponentially) over time.
- Because investments with higher costs have to overcome these expenses, their performance tends to suffer vs. lower-cost investments.
How to invest
Don't let high costs eat away your returns
They say you have to spend money to make money. But the money you pay to invest has a big effect on what you have left in your own pocket.
6 minute read
Understand what you're paying
Every investment has a cost, even if you don't realize you're paying it.
There are many different kinds of costs, but they all have one thing in common: If the money is going somewhere else, it's not going to you.
Why do costs matter?
Investment costs might not seem like a big deal, but they add up, compounding along with your investment returns. In other words, you don't just lose the tiny amount of fees you pay—you also lose all the growth that money might have had for years into the future.
Imagine you have $100,000 invested. If the account earned 6% a year for the next 25 years and had no costs or fees, you'd end up with about $430,000.
If, on the other hand, you paid 2% a year in costs, after 25 years you'd only have about $260,000.
That's right: The 2% you paid every year would wipe out almost 40% of your final account value. 2% doesn't sound so small anymore, does it?
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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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Returns
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.
Costs can eat away at your investments
This hypothetical illustration doesn't represent any particular investment nor does it account for inflation. "What you lose to costs" represents both the amount paid in expenses as well as the "opportunity costs"—the amount you lose because the costs you paid are no longer invested. There may be other material differences between investment products that must be considered prior to investing. Numbers are rounded. The rate is not guaranteed.
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Costs can eat away at your investments
This chart shows how investment costs can eat away at your savings. If you have $100,000 invested, it could grow to $430,000 without any investment costs. But if you pay only 2% a year in costs, it could grow to only $260,000. You would lose about $170,000 to costs.
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What can you do to control your costs?
Because all investments have costs, it might seem like a waste of time to worry about them. Or maybe you assume that a higher price means higher quality.
But nothing could be further from the truth. Research on mutual funds has shown that higher-cost funds generally underperform lower-cost funds.* That's because the fund managers charging these costs have a difficult time adding enough value to overcome the additional expense.
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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.
Funds with lower costs have outperformed more expensive ones
This illustration compares the annualized returns (for the 10 years ending December 31, 2014) of the median funds in two groups: the 25% of funds that had the lowest expense ratios as of year-end 2014 and the 25% that had the highest, based on Morningstar data. Returns are net of expenses, excluding loads and taxes. Both actively managed and index funds are included, as are all share classes with at least ten years of returns. Source: Vanguard calculations using data from Morningstar.
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Funds with lower costs have outperformed more expensive ones
This chart shows that on average, funds with lower costs have outperformed those with higher costs. The median U.S. stock fund in the highest-cost quartile had an average yearly return of 6.9%, while the median fund in the lowest-cost quartile had an average yearly return of 7.8%. The median U.S. taxable bond fund in the highest-cost quartile had an average yearly return of 4.0%, while the median fund in the lowest-cost quartile had an average yearly return of 4.4%.
GOOD TO KNOW
Mutual funds are frequently offered in different share classes. The funds' objectives, management, and underlying investments are identical across all classes. But each class could have different expense ratios, minimums, or both.
Don't get fooled by marketing tactics
Some funds may charge extremely low expense ratios—but add front- and back-end loads. Or they may offer an "introductory" or short-term expense ratio that increases later on. Or they might undercut their costs on one fund but jack up costs on the others to make up for it.
The bottom line?
There are certainly some things you shouldn't bother worrying about when it comes to investing. But costs are one of the driving factors that dictate whether you'll reach your goal—and they're one of the only factors completely within your control. So give them the time and attention they deserve.
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Expense ratio
Fees charged to investors to cover operating costs, expressed as a percentage. The money is deducted from investment returns before they're given to investors. For example, if you had $10,000 invested in a fund with an expense ratio of 0.20%, you'd pay about $20 a year out of your investment returns.
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Load
A sales fee charged on the purchase or sale of some mutual fund shares. The load may be called a charge or commission. The fee may be a one-time charge at the time the investor buys the fund shares (front-end load) or sells the fund shares (back-end load).
*Source: Vanguard, Shopping for Alpha: You Get What You Don't Pay For (Wallick et al., 2011).
All investing is subject to risk, including the possible loss of the money you invest.