You probably know that expenses matter in investing, but you may not realize just how much they matter. When I tell people to "get real" on expenses, I mean comparing expenses to the real, inflation-adjusted expected return on your portfolio.
While no one knows with certainty what tomorrow's market performance will be, earlier this year Christine Benz, Morningstar director of personal finance, interviewed experts on their predictions of returns for stock and bonds.
I then made a few calculations from their estimates, using an assumed 2 percent inflation rate (the Federal Reserve's target) to gauge the future average annual return for stocks and bonds over the long term. Based on the consensus of the experts Benz interviewed (with the exception of one extreme outlier whose prediction would only make my case about expenses even more dramatic), here's what I came up with:
- Stocks: 4 percent average annual real return after inflation.
- Bonds (high quality): 1 percent average annual real return.
Applying these predictions, I figure a portfolio of half stocks and half bonds has a long-run expected real return of about 2.5 percent.
How much of this 2.5 percent annual real return are you giving away to expenses? According to a Morningstar fee study released last year, the average mutual fund had an annual expense of 1.19 percent in 2014. This means that if you are invested in average funds (with 50 percent each in stock and bond funds), you took on all of the risk yet gave away nearly half of the return. And it gets worse if you paid your adviser a 1 percent annual fee to be in these funds, because your 2.19 percent total fee is giving away about 88 percent of the expected returns.
People seem to be getting smart about expenses, as Morningstar data reveals that investors are increasingly moving from high-fee funds into lower-fee funds. But this data also reveals that investors still paid an average annual fee of 0.64 percent, which is giving away more than 25 percent of the expected return for a 50-50 stock and bond portfolio.
I typically recommend ultra-low-cost broad index funds. For example, these three:
- iShares Core S&P Total U.S. Stock Market ETF, expense ratio 0.03 percent
- Vanguard Total International Stock ETF, expense ratio 0.13 percent
- Vanguard Total Bond Market ETF, expense ratio 0.06 percent
With funds such as these, you can build a portfolio with annual fees well under 0.1 percent.
You've worked hard and saved for your future. My advice is to transfer as little as possible to others in the way of fees.
Allan Roth is the founder of Wealth Logic, an hourly-based financial planning firm in Colorado Springs, Colo. He has taught investing and finance at universities and written for Money magazine, the Wall Street Journal and others. His contributions aren't meant to convey specific investment advice.
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