When “You Get What You Pay For” Doesn’t Apply

"Don't mind if I do" said the broker.

“Don’t mind if I do” said the broker.

Depending on who you ask, investing can be many different things.  Talk to a young day trader, and investing is a heart wrenching, gut busting and sweat inducing race that never ends.  Ask a guy in his fifties who has been passively investing in his 401k throughout his working years, and he might tell you he checks his investments once a month.  Some people enjoy the number crunching and up to the millisecond information they can get from day trading, while others enjoy doing other things in life and let their investments grow on their own in the background.

There is one thing in common in both these scenarios, however, and it presents itself in different ways.  And that is investment fees.  Everyone knows there is a cost to do business.  When you get the dinner bill, you’re not just paying for the food.  You’re paying the restaurant employees’ salary, the rent and utilities.  The same goes for investing.  When you invest in a stock or a mutual fund, you’re not just paying for the privilege of investing.  You’re paying the company that facilitates the trade, the manager who manages the mutual fund and everyone in between.  This means that every time you make a trade, you automatically generate negative returns because your investment needs to make up the cost of your transaction just to get back to square one.

While we can’t avoid all fees, there are two types fees that we can try to minimize:

Trading fees

Any time you buy or sell a stock or mutual fund, there is a trade involved that costs you money.  Here are some ways to minimize this fee:

Trade less.  This is more or less what is known as “no-brainer.”  In order to minimize the fees racked up from each trade, try to trade a little less.  This is not feasible for some investors like our day trader friend, but for someone who is investing for the long term, it doesn’t make much sense to make frequent trades because it doesn’t give the investments time to grow and the fees will just eat at your returns.

Consider an online brokerage.  There was once a time when trades were made over the phone.  This was expensive because there was a broker involved, and anytime a middle man is involved, you gotta pay.  The vast majority of trades nowadays are done online, which makes things easier for the investor and the broker.  Scottrade, for example, is an online broker known for its low trading fees.  It costs $7 per trade when you use the internet.  Making a trade over the phone costs $32.  Almost five times as much!

Trade big.  If you buy one dollar worth of Apple shares, you will pay a flat trading fee.  If you buy $1000 worth of Apples shares, you will pay the same flat trading fee.  You want that fee to be as small of a percentage of your investment as possible.  Making 10 separate stock purchases of $100 each with a 7$ fee will cost you $70 in fees.  That’s 7% of your money already going towards fees.   Making one single purchase of $1000 will cost $7 in fees, 0.7% of your money going towards fees.  Another no-brainer.

Expense ratio

An expense ratio is what it costs a company to operate a mutual fund.  It’s usually expressed as a percentage, as in what percentage of your money the company takes.  Expense ratios vary wildly from fund to fund, and a higher expense ratio doesn’t mean you’re getting more expertise.  It just means that you’re paying more for the privilege of investing with that fund.  In fact, having a higher expense ratio just means you have to earn that much more in returns to get back to where you should be.

Here are a few ways to keep that expense ratio low:

Look at it.  It’s that simple.  As of last year, mutual funds are required to make their expense ratio front and center, not hiding behind an avalanche of fine print.  This makes it easier than ever to avoid fees.  If you’re looking for a great Target Retirement Fund, a mutual fund that shifts its asset allocation over time, you can easily see which one has the lowest expense ratio.  Recent returns may or may not give an accurate picture of the fund’s performance, but a low expense ratio can assure that more of your money will be going towards your investments.

Consider individual funds.  Many people love the aforementioned Target Retirement Funds.  They automatically shift your asset allocation towards “safer” investments as you near retirement.  This will help avoid any major aftershocks to your portfolio like the one that occurred after the 2008 crash.  Many almost retirees who were heavily invested in stocks lost a lot of money, and either had to put off retirement and continue working or try to live off of less money.  A Target Date Fund will automatically adjust your portfolio as time goes on, making it almost idiot proof.

Almost.  There are many out there who are not fans of Target Date Funds, and one reason is that they carry relatively high expense ratios.  Vanguard, which is the bastion of mutual funds with low expense ratios, has a Target Date Fund called Vanguard Target Retirement 2050.  It’s for those investors who predict they will retire in the year 2050, when flying cars will obviously be the norm.  The expense ratio for this fund is 0.18%, a very low ratio by most companies standards.  The Vanguard Total Stock Market Index Admiral fund, a fund that simply invests in the broad US stock market, has an expense ratio of 0.05%, almost four times less than the Target Fund.  The Vanguard Total Bond Market Index Admiral fund has an expense ratio of 0.08%.  Both of these funds have a much lower ratio than the Target Date Fund.

The point is, Target Date Funds are great and have relatively low expense ratios, but you can do better.  Investing in an overall stock and bond fund and adjusting your allocation yourself takes a little more work, but will save you money in fees.  Again, you can do a lot worse than a Target Date Fund, but we want to be the best don’t we???!!!

These are just two types of fees that any investor can try to minimize.  We all try to save money on things like car insurance, electricity and cable.  No one likes paying more for something if they don’t have to.  The same thing applies to investment fees.  Remember, any amount you pay in fees is money that is working for someone else and not for you.

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Comments

  1. Kim says

    Excellent point about fees. I think that is something most people don’t pay enough attention to. I would never fault anyone for a target date fund. We actually have our daughter’s IRA in one right now, but I do like to be more proactive with the funds we need to retire on. Hers is just a gift and she can change it when she is old enough!

    • Syed says

      I agree a Target Fund is definitely better than what the majority of the population does, but you can do better with a little bit of work. Thanks for the comment!

  2. This made me think of FeeX. Have you heard of it? I blog for them a couple times a week. Essentially their tool analyzes fees in your retirement account and recommends funds that charge less. They also make sure you are aware of exactly how much you are paying in fees. Something worth checking out imo.

    • Syed says

      I have heard of them I’ll have to check out that tool. Thanks for the tip.

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