Last year one of my largest expenses was one I never saw. I didn’t get a bill for it. And I didn’t have to pay it, at least not directly. But it still cost me a small fortune. I’m talking about investment costs in the form of mutual fund expenses.
Mutual fund expenses present two big problems. First, because you don’t actually get billed for them, it’s easy to forget about them. The cost comes out of your investments, so you never have to write a check for the expense. If you invest in mutual funds through a 401k, IRA or taxable account, you have the same problem.
The second problem, and the one we are going to look at today, is that even small expenses can add up over time. Because we save and invest for retirement over several decades, even half a percent can have a huge impact on our retirement. In fact, an extra 0.50% paid in mutual fund fees can be the difference between a comfortable retirement and living on a shoestring budget.
Here’s why expenses are so important. The difference between paying say 0.5% and 1% in fees for your mutual funds is ENORMOUS over a 40 year (25 to 65) investment period. Here’s the math, assuming you start with nothing and add $1,000 a month to your retirement savings (take a guess at the difference before you read on):
|Average Return||Balance after 40 Years|
So given the effect of even 0.50% on retirement savings, there are two things we need to do: (1) determine the cost of our retirement investments; and (2) depending on the results, make changes to reduce our costs.
Determining the cost of your investments
If you have invested in just one mutual fund, determining your investment costs is easy—just look at the fund’s expense ratio. If you don’t know where to look, simply get the ticker symbol of your fund (which should be on your last statement) and enter it into the Google search box. For example, when I enter VEIEX (a Vanguard emerging market index fund that I’ve owned since 2002) into Google, this is the first result:
As you can see, the expense ratio is 0.35%. That means that for every $100 invested in the VEIEX fund, you’ll pay 35 cents in expenses each year.
Now, if you own more than one fund, you’ll want to calculate your weighted average cost. To do that, for each fund you own perform the following calculation:
Amount invested in fund / Total invested in all funds x Fund’s expense ratio
So for example, if I had $10,000 invested in VEIEX and a total portfolio of $100,000, my calculation for VEIEX would look like this:
$10,000 / $100,000 x .35% = .035
Perform the same calculation for each fund you own, and add up the results. What you’ll get is the weighted average cost of your funds.
And if you hate math, then track your portfolio in Morningstar (it’s free), which calculates the weighted average cost of your portfolio for you (here are the details).
You should aim for a weighted average cost of no more than 0.5%, in my opinion. If your costs are significantly higher, keep reading.
How to reduce the cost of retirement investing
There are several ways to reduce the cost of investing for your retirement:
- Invest in index funds: Index funds generally have significantly lower expense ratios than do actively management funds. Because index funds track an index like the S&P 500, you don’t have to pay for the cost of investmen managers to evaluate and pick stocks. And the performance of index funds generally beat managed funds over the long haul anyway.
- Invest in ETFs: Exchange traded funds typically have a lower expense ratio than identical mutual funds. You do have to pay a brokerage fee to buy ETFs, but unless you are an active trader, the fee should be less over the long term than the extra expenses you’d pay for a mutual fund. I recently purchased ITF for my SEP IRA at Scottrade. The brokerage fee was just $7.95.
- Reduce trading costs: If you are a fairly active trader, you must watch the transaction costs of your investment activity. There are plenty of low cost online brokers to choose from. I use Scottrade because it has branches everywhere, but you can find even less expensive brokers like OptionsHouse ($3.95 stock trades).