Most of the time higher quality things cost more money. As the saying goes, “you get what you pay for.”
But the opposite is true when it comes to investing. Research has shown again and again that lower cost investments perform better. Quite simply, the less you pay, the more likely you are to get better returns.
And the great thing is that cost is one of the few investment variables you can really take charge of. You can’t control or predict how the markets will perform, but you can definitely control how much you pay to be in the market.
The bottom line is that finding lower cost investments is one of the easiest and most effective ways to increase your investment returns. Here’s how to do it.
Two Big Investment Costs to Watch Out For
For most people, the majority of their investment costs will come from the following two places. If you can minimize these two things, you’ll be in good shape.
1. Expense Ratio
Every mutual fund or exchange-traded fund (ETF) has something called an expense ratio, which is simply the annual cost of investing in the fund. That money is used to pay for the cost of managing and administrating the fund for you.
The expense ratio is charged as a percent of the money you have invested in the fund. So if a particular mutual fund has an expense ratio of 1%, that means that 1% of the money you have invested in that fund will be taken out as a fee each year.
And while 1% may not sound like much, it can add up to a huge difference over a long period of time. Assuming you contribute $5,500 per year and earn an 8% annual return, a 1% difference in fees will likely lead to more than a $100,000 difference in retirement savings over a 30-year period.
In other words, you’ll want to pay close attention to your expense ratios and minimize them as much as possible. Most good mutual funds these days have expense ratios of 0.2% or lower, though some specialized funds might go as high as 0.5%.
2. Sales Loads
Sales load is a fancy term for commission. It’s a percent of your investment that goes to the person who sold it to you.
For example, if you contribute $1,000 to a mutual fund that has a 5% sales load, only $950 will actually go into the fund. The other $50 will go to the person who sells you that mutual fund. And that will be true for every additional contribution you make to that fund in the future.
There are two big things to understand about sales loads:
- Not all mutual funds or ETFs have them. In fact, it’s pretty easy to avoid them.
- Research has shown that mutual funds with sales loads underperform those that don’t have them.
For those reasons, it will usually make sense to avoid mutual funds that have a sales load. There are simply better options out there.
Four Other Investment Costs to Watch Out For
While expense ratios and sales loads are the two biggest costs to watch out for, there are plenty more to keep an eye on. Here are four of the most common.
Depending on the company you use to do your investing, you may be charged a fee each time you buy or sell an investment. For example, E*TRADE currently charges $9.99 per ETF trade (with some exceptions) and between $0 and $19.99 for mutual fund trades.
And while that may not sound like much, it can add up pretty quickly. If you make monthly contributions to three ETFs, you’ll end up paying about $360 per year just for the privilege of contributing.
Of course, there are ways around this. For example, major investment companies like Vanguard, Schwab, and Fidelity allow you to trade their own funds for free. And many ETFs are commission-free on certain platforms. So there are plenty of ways to eliminate or at least minimize this cost.
If you’re investing in a retirement account like a 401(k) or IRA, you don’t need to worry about taxes until you start taking withdrawals.
But every trade within a taxable account is subject to potential taxes, and the more you trade, the more you may have to pay. And even if you never sell anything, the mutual funds you own will make trades, and those tax consequences will be passed on to you.
We all have to pay our fair share in taxes, but there’s no need to take on more than that. In general, the less often you trade, and the more tax-efficient your investments, the less you’ll have to pay in taxes.
Whether you work with an investment adviser who manages your money for you or you invest through a company like Betterment, there’s a cost to having someone else in charge of your investments.
And while that cost can be worth it, make sure you know what you’re getting and that you’re not paying more than you should.
Account Maintenance Fees
Some companies will charge you a monthly or annual fee simply for the service of providing you with an account.
These can often be avoided by meeting certain conditions. For example, Vanguard charges a $20 annual fee for IRAs, but it’s waived if you either sign up for e-delivery of statements or you have a certain total account balance with them.
In some cases, like with health savings accounts, a small maintenance fee might be unavoidable. But in most cases there’s no need to incur this kind of cost.
The Bottom Line: Lower Costs = Better Returns
Watching out for fees may sound kind of boring, but it’s one of the easiest and most effective ways to improve your investment returns.
Remember, not only does a smaller fee mean that more of your money is invested, but the research shows that lower cost investments actually perform better.
It’s a double win that you should definitely be taking advantage of.