I’ve recently been reading a book on mutual fund investing by John C Bogle, the founder of Vanguard. His book, “The Little Book of Common Sense Investing” has really challenged what I thought I knew about investing in mutual funds and that way I encourage others to do so. For a while, I thought that returns was really all that mattered – if you picked a ‘winner’, that’s all that should matter, right? The book helped me think through a number of reasons why that wasn’t the case, and introduced a number of reasons why you may not actually be winning, even when it feels like it.
The overlooked costs of managed funds
Hopefully before investing in a mutual fund, you’re taking a look at the expense ratio. Expense ratios are the percentage of the fund’s assets that are taken out as fees for the management each year. The fund’s managers are doing a job; you are paying them to manage your money in the fund. You should try to minimize the fees you are paying your investor. Although you think that more fees should mean better returns, far too often it is not the case. As time goes on, you’ll little by little have your precious gains eaten up by fees. As a good rule of thumb, definitely keep the fee under 1%, and honestly 1% might be a little high! A good index fund (will get into that next) will charge super low – the Vanguard 2055 Retirement date fund has expenses of only 0.16%! Another overlooked fee is the load, which basically is an upfront fee charged to let you join the club. Definitely look for funds without a load. Finally, be sure to check out the turnover ratio. The turnover ratio is how often the fund if buying or selling the stocks that they own. A higher turnover ratio of like 50% means that 50% of the stocks are bought and sold each year. There are fees associated with transactions (it’s not free to buy or sell) and a higher turnover ratio can eat away at your returns.
Simply put, don’t just pick a mutual fund by it’s average return over the past few years. A high return is nice, but fees can eat away from that return, bringing what looks to be a good investment down to a bad investment!
Buy the haystack instead of the needle
Picking stocks is hard. Even for someone like me who enjoys the stock market game, does a lot of reading, has a financial blog, it is not easy! Stocks are not predictable, can go up and down without reason, and can defy common sense understanding. For every one stock you might pick right, you’ll probably take a loss on two others. Even professional money managers (you know the ones you pay those fees to) aren’t super good at it either. You may get lucky, but it’s tough to consistently be lucky. In John’s book, he speaks of owning the entire haystack, instead of just the needle. Such a concept is called an “index fund”, in which you basically own hundreds of stocks, instead of just concentrating on a few. In this manner you’ll have some big wins, some losses, but overall will be more likely to come out on top. With less stocks (i.e. a more focused mutual fund), you might win, but you might also lose. By spreading your bets across more stocks, you’re winnings will average out to a return that is healthy for young investors like us, returns that over a long period of our lifetime will allow us a comfortable retirement! I will confess that I used to be quite skeptical about index funds, but after comparing my wife’s 401(k) performance (all index funds) to my highly targeted and selective funds, I was amazed to find that her index fund did better than mine!
Even the greatest don’t always win
Michael Jordan (sorry – Lebron James for my younger readers) didn’t win every game he played in – despite being the GOAT (greatest of all time). Same goes for financial advisors. Sure big bank names like “JP Morgan Chase” or “Merrill Lynch” sound fancy and sure you might think you’re picking winners but going with a ‘very focused’ fund, but the reality is that even the greatest don’t always win. Even Warren Buffet, probably the most legendary investor of all time recommends low cost index funds. “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients”…”both large and small investors should stick with low-cost index funds”. If you can’t guarantee a win, why not come as close as you can by betting the whole field with an index fund!
Researching and writing this article was eye opening for me. I found that some of my investments that I thought were solid actually carried some pretty hefty fees with them (0.75%). I took the time to review my portfolio and found other funds that had similar returns, at half the cost. Definitely play an active role in managing your retirement account and find funds that are low cost! Otherwise if my feel like you’re winning but in actuality you might not be!