The Ignorant Investor

How important is it to keep expenses low when buying mutual funds? I've been fretting over having money in one of Schwab's index funds because its 0.37% expense ratio is far higher than equivalent funds offered by Fidelity and Vanguard, which come in at .10% and .18%, respectively. But the difference in the realized gain between funds with a .10% or .37% expense rate seems minor when compared to the 1% or 1.5% charged by many managed funds.

Assuming an initial $100,000 investment (Yeah, I could have used $10,000- BUT LET'S THINK BIG TODAY!), and a seven percent average annual real increase in stock prices (i.e., inflation stripped out) after ten years the investment grows to:

Expense
Ratio
.10% - 182,305
.18% - 181,081
.37% - 178,203
.50% - 176,257
1.0% - 155,133
1.5% - 148,610

As you can see, the differences between the Schwab fund and the Vanguard or Fidelity funds is pretty minor. A few thousand dollars, which we'd rather have, but nothing we can't live with. The same can't be said for the average mutual fund, which is going to be worth about $20,000-$30,000 less in today's dollars. That's not chump change. That's a good years worth of income for many retired folk.

A better way to look at it is in a chart. Taking out the initial $100,000 investment and looking only at gains, that blue area there is what you get to keep and play with after 10 years. It's pretty clear that the person who went with the mutual fund with higher fees is going to have a whole lot less to play with. All that empty gray space that is a beautiful blue on the left? That's the barren spot where your money would have been if you'd stayed away from that high-fee fund.



Active managers will say that they can grow money faster than the averages, but every one of them is fighting an uphill battle because of those high fees. But those fees are why they work. They have to take a big share of your gain every year in order to buy the houses in Greenwich, the new BMW, the trips to Bermuda and Europe. They can't live otherwise. These guys aren't priests, and they don't take a vow of poverty.

I wouldn't mind if they actually could deliver on the promises of superior gains, but all but a very few can't. As David Swenson as often says, what you get from active management is usually worth far less than what you pay for.

So the rule is: stick with mutual funds with expense ratio's under .50%. There are good funds out there, even actively managed ones, that deliver quality service without costing the mutual fund equivalent of an arm and a leg.