Investing

Investing for Retirement: Controlling Your Costs

Introduction

Among many other contributions, John Bogle was an evangelist of the “Cost Matters Hypothesis“:

The overarching reality is simple: Gross returns in the financial markets minus the costs of financial intermediation equal the net returns actually delivered to investors…. No matter how efficient or inefficient markets may be, the returns earned by investors as a group must fall short of the market returns by precisely the amount of the aggregate costs they incur. It is the central fact of investing.1

In other words, the greater your investment costs associated with financial intermediation, the less you ultimately receive in savings. These costs may include brokerage commissions, sales loads, management fees, financial advisory fees, bank trust department fees, advertising costs, and lawyers’ fees. You cannot beat the market because it is a zero sum game. Financial intermediation means that beating the market is a loser’s game.

“You put up 100 percent of the capital and you assume 100 percent of the risk. But you earn less than 40 percent of the potential return.”

–John Bogle2

Earlier, we introduced the concept of compounding, both with regard to savings and inflation. Bogle quantified the drag of recurring investment costs over time: assuming a nominal gross return on equities of seven percent, based on the historic average over the past 50 years, $10,000 would grow to $294,600. Assuming average costs of two percent per year, then your net return would be reduced to five percent. But, your net return would be reduced by over one half: you would receive only $114,700.3 Thus, you can see the considerable impact on your portfolio of compounding both costs and taxes: your portfolio lost over eighty percent of its final value!

 

The High Costs of Active Management

John Bogle estimated that the all-in-cost of actively-managed fund ownership is 2-3% per year:

  • Your expense ratio (management fees + operating expenses) may average 1.3% per year of fund assets
  • You should also factor an additional 0.5-1.0% in sales charges or annual incentive sales fees to the broker for up to five years
  • Finally, portfolio turnover can add an additional 1% per year in commissions, bid-ask spreads, and market impact costs4

You should also be mindful of incremental fees and expenses beyond just the funds’ management fees. For example, some funds charge additional advisory fees, investment research fees, 12b-1 marketing and distribution fees, and other expenses. Shareholder fees may include front-end sales loads or back-end or deferred sales loads. Even “no load” funds may charge purchase fees, redemption fees, exchange fees, and account fees.5

Relative Predictability

As John Bogle stated,

“The beauty of relative predictability is that funds with similar objectives and strategies tend to earn similar gross returns. Therefore, the funds with the lowers costs are likely to earn higher net returns. A fund with an advantage of some 1.5% in total annual costs (including expense ratios, turnover costs, and sales loads) would provide a 20% advantage in return over its peers during a full decade, without assuming any additional risk.”6

Summary

Coming Soon!

For More on this Topic



Updated on February 13th, 2019

  1. Bogle, John. “The Relentless Rules of Humble Arithmetic” Financial Analysts Journal. November/December 2005.↩

  2. Bogle, John. The Little Book of Common Sense Investing. John Wiley & Sons. 2017. ↩

  3. Bogle, John. The Little Book of Common Sense Investing. John Wiley & Sons. 2017. See also, Bogle, John C. Enough: True Measures of Money, Business, and Life. New York, John Wiley & Sons. 2010.↩

  4. Assuming an average 100% portfolio turnover.↩

  5. https://www.sec.gov/fast-answers/answersmffeeshtm.html↩

  6. Bogle, John C. Stay the Course: The Story of Vanguard and the Index Revolution. John Wiley & Sons. 2019.↩