Why Costs Matter

WHEN THE STOCK MARKET can soar 30% in a year and individual stocks can quickly double, investment costs might seem like a minor issue. But the market doesn’t soar 30% every year, and most of our stocks, if they double in value, will likely take many years to do so.

Indeed, in a lower-returning market, costs can loom large. Suppose the stock market notches 6% a year. If you lose 1.5 percentage points to mutual fund expenses and other costs, you would be left with 4.5%. Trade frequently? You could surrender a quarter of your annual gain to taxes, which means your 4.5% would become less than 3.4%. That might not seem so bad—unless inflation is running at 3%, in which case you’re making almost nothing.

You can’t do anything about inflation. But you can do your best to hold down investment costs and minimize taxes. Let’s say you bought a mutual fund that charges 0.5% in annual expenses and held it inside a Roth IRA. Even if the fund’s manager picks stocks that perform no better than the market, you would earn a 5.5% tax-free annual return, leaving you comfortably ahead of the 3% inflation rate.

It’s easy to overlook investment costs or dismiss them as a trifling matter. We sit up and take notice when we’re charged a $35 overdraft fee, but we might be oblivious to a fund’s 1% expense ratio—and yet that 1% would be costing us $1,000 a year if we have $100,000 invested. The problem: Fund expenses are stated as a percent of assets, which makes them appear small. What if, instead, they were stated as a percent of our likely return? Paying 1% of assets might not seem so bad. Losing 17% of our potential 6% return sounds a whole lot worse.

Despite Wall Street’s efforts to play down investment costs, investors are increasingly aware of the damage done by high expenses. In recent decades, investors have shoveled money into low-cost index funds—a well-known trend. But they’ve also favored actively managed funds with lower annual expenses, while eschewing high-cost active funds.

So which costs should you watch out for? Try to keep a close eye on trading costs, fund annual expenses and the amount you pay for financial advice, all of which are discussed in the sections that follow.

Next: Trading Costs

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