Wouldn’t it be incredible if there was something akin to a magic bullet when it comes to investing? Something you could do, almost mechanically, that would dramatically boost your eventual income in retirement? Well, there is! I know it sounds too good to be true, but it isn’t. Let me explain…
The One Magic Bullet In Investing…
The number one predictor of future investment performance of a mutual fund probably isn’t what you think. It isn’t past performance, it isn’t the reputation of the manager, and it isn’t even the fund’s investment style. So what is the best way to predict future investment performance? The expense ratio.
Not only are expense ratios the best predictor of future mutual fund performance, it’s actually the only reliable predictor. In a study by the famous investment research firm Morningstar, expense ratios predicted superior future performance in 100% of tested periods. From the study:
Expense ratios are strong predictors of performance. In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.
You read that correctly, folks: in every asset class over every period cheap funds beat high-cost funds. That’s remarkable.
You can read the full study here (you’ll need to create a free account in order to access the story).
How Much Of An Impact Can You Really Expect?
In a word, huge.
Research has shown that all else being equal, a mutual fund will trail its index by the amount of its expense ratio. That is, an actively-managed mutual fund with a 1% expense ratio will tend to trail its index by 1% per year while an index fund with a 0.15% expense ratio will trail its index by 0.15% per year. By extensive, the low-cost 0.15% mutual fund will tend to out-perform the high-cost 1% mutual fund by 1% – 0.15% = 0.85% per year.
An example will help illustrate just how important squeezing an extra 0.85% per year out of your investment portfolio can be.
John is a successful engineer and earns a decent living but isn’t particularly interested in investments. Therefore, he pays an advisor to help manage his investment portfolio. Let’s pretend for the sake of argument that John uses an advisor with average ability with very reasonable rates and say his all-in costs are 1% per year (they would probably be much higher than this in the real world, but we’ll cut him some slack).
Starting at age 25, John invests $500 per month in his portfolio for 40 years until he retires at age 65. If the stock market is generous enough to return 10% per year over that period, John can realistically expect to have earned a 9% annual return (10% – his 1% in total expenses) over the same period. John will retire with approximately $2.34 million.
Sally is also a successful engineers and, pretending she lives in some alternate universe where women actually earn the same pay for doing the same work, she also invests $500 per month over the same 40 year period of time. The main difference, though, is that Sally is a savvy investor and owns only low-cost index funds with an average expense ratio of 0.15%. She also does her own investing and so doesn’t need to pay an advisor on top of what she’s already paying in management fees to the fund company.
Sally can realistically expect to earn 9.85% per year on her money (10% – 0.15%). Now 0.85% per year may not sound like a lot, but over the long run it really adds up. Sally will end up with approximately $3.021 million on the day she retires, or about 30% more than John!
Action Steps To Boost Your Retirement Income By Almost A Third
The cool part about this technique is that it doesn’t require any actual work on your part! In fact, Sally will actually end up doing LESS work than John because using expenses as a primary selection criteria greatly simplifies the investment-picking process. It is, quite literally, a set-it-and-forget it strategy.
- Choose index funds over actively-managed funds – Index funds have a built-in cost advantage over active funds because they don’t need to pay a hot-shot fund manager and an army of analysts to choose investments for them. Most of the work can be done by computers, which dramatically decreases operating costs.
- Stick with broad-market index funds – While experienced investors might have legitimate cause to slice and dice their portfolios, the vast majority of small investors would be better served sticking with broad-market index funds such as Vanguard’s or Fidelity’s total stock market index funds and total international stock market index funds. There’s no need to get cute. Broad market funds are naturally less costly than more specialized holdings like small-cap value funds, emerging market funds, etc.
- Go with the three fund portfolio – The three fund portfolio is tried and true. It’s cheap, efficient, simple, and most importantly, it’s effective. Complexity tends to harm investment returns rather than help them, so why bother? Keep it simple, stupid. Wise advice.
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