Investment costs are calculated in small percentages called expense ratios, and they make a huge difference in portfolio value. Those who direct their own investments spend time studying measures like fair value, dividend growth rate, and potential returns, but often ignore investment costs.

The lower your cost the greater your potential return. That cliche’ carries enough weight with me to review drag on investment returns and how it lowers income potential. But, don’t just take it from me.

This is what the great John Bogle, founder of Vanguard and index fund pioneer says, “an investor with minimal curiosity will learn that the shortest and surest route to top-quartile performance is bottom-quartile expenses.

Research has shown that stock portfolios managed for minimal expenses and greater tax efficiency have out performed over the long haul. Markets are unpredictable and you can’t control volatility, but you can keep the impact of costs and tax bite low.

Every basis point matters and the only sure way to give yourself an investment boost is to decrease expenses. Think of costs this way. Every added fee is less money you’ll keep for yourself.

From the March 2005 issue of Investment Advisor, Andrew Gluck wrote this about investment costs:

  • The S&P 500 between 1974 and 2003 showed a 12.19% average annual return, and a $10,000 investment grew to $315,000
  • Earning just one percentage point less annually, 11.19%, would have meant a $241,000 terminal value
  • Two points less would have meant a $184,000 terminal value
  • Three points less would have been a $140,000 terminal value
  • And four points less would have been a $106,000 terminal value
  • So annually losing four points of the S&P 500’s 12.19% return to expenses would have slashed an investor’s terminal wealth by two-thirds

Here’s a list of common expenses that sneak investment dollars away from you. All can have enormous impact on investments of any size, moving a high return portfolio into an average return one. I won’t cover each in detail but a visit to Investopedia will give a summary of each one:

  1. Fund management costs
  2. Trading costs
  3. Advisor support
  4. Fund manager trading activity
  5. Your own trading activity
  6. Tax impact (dividends and capital gains = 15%-20%)
  7. Markups/Markdowns (Bond wholesale to retail spread)

Consider the average equity mutual fund with associated fees to highlight costs vs. returns.

  • Advisory fees 1.1%
  • Other operating expenses 0.5%
  • Total expense ratio 1.6%
  • Transaction costs 0.7%
  • Opportunity cost 0.4%
  • Sales charges 0.6%
  • Total Annual Cost 3.3%

http://www.freemoneyfinance.com/2006/10/costs_matter_if.html

To see the impact of 3.3% expenses in real dollars, let’s consider a hypothetical example using managed funds.

You receive an unexpected inheritance of $100,000 and consider three funds for investment. Each fund returns 8% over a twenty year period. Fund A charges 1% management fee, fund B charges 2%, and fund C costs 3% per year.

Here’s the tally after 20 years:

  • Fund A return = $386,968
  • Fund B return = $320,713 ($66,255 less than A)
  • Fund C return = $265,329 ($121,639 less than A)

You can see the lost money as expenses creep up.

I’ll throw in a Fund D for fun to show how a really low-cost investment pays off.

Fund D – Index Fund = $444,985 (added over $57,000 vs. Fund A)

Here are things you can do to manage investment costs:

  1. Understand fees associated with any investment and get clarity on any cost you don’t understand.
  2. Put a dollar figure to expenses like the example above. Moneychimp an easy to use website for figuring costs and returns.
  3. Adviser’s should clarify all costs, using both percentages and dollars, so you fully understand what you’re paying – if not move on.
  4. If directing your own portfolio, control cost by trading infrequently.
  5. Find a similar fund or other investment if the one you’re in now is too costly.
  6. Use an index fund or index exchange-traded fund to keep fees really low.

Ralph Waldo Emerson, the noted Transcendentalist, once observed, “Money often costs too much.” You can’t argue with that, since it is your hard-earned money at stake. In the investment world, you don’t always receive good value for what you pay, so conduct your own due diligence when it comes to fees, commissions, and other charges. Remember, too, the real cost story is an index fund, offering the best chance of pocketing long-term market returns, with the lowest fees.

http://www.youtube.com/watch?v=ZsxHHGXS7BMhttp://www.youtube.com/watch?v=l4s33_L8Gzw