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Nancy Graham CPA, CA, CIM, CFP, TEP

Portfolio Manager
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Harnessing the Power of Cost Management

November 21, 2014 - 0 comments

As we touched on in one of our previous posts, Practical Investing, one simple way to exert more control over your investment outcomes happens to also be one of the most overlooked ways: minimizing unnecessary costs.

Stock Fund Sticker Shock
You probably don’t ignore prices when you’re a consumer. You may agree to spend more on one product over another, but only if you’ve determined that the quality and/or quantity involved justifies the extra expense.

Similarly, as an investor, expenses can range anywhere from reasonably justified to outrageously overpriced. When comparing one strategy or solution to another, it’s important to be aware of the costs involved for the quality expected, so you can make informed decisions that serve your best interests.

How do you go about assessing an investment’s value? Perhaps we’re stating the obvious, but before an investment can generate net returns, it must first add enough value to cover its costs. And while the statement may be obvious, it is far from a given for most investments available.

Consider the evidence from the following illustration, which compares less-expensive to more-expensive stocks funds (as measured by their expense ratios) and how often they were able to outperform their appropriate benchmarks. Bottom line, especially over a longer term, the more expensive a fund was, the less often it was able to beat its benchmark. And that’s before we even consider the advisability of the strategy involved.

High Costs Make Outperformance Difficult
(Equity Fund Winners and Losers According to Expense Ratios)

Source: Dimensional Fund Advisors
The sample includes funds at the beginning of the one-, five-, and 10-year periods ending in 2013. Funds are ranked by quartiles based on average expense ratio over the sample period, and performance is compared to their respective benchmarks. The chart shows the proportion of winner and loser funds within each expense ratio quartile. Past performance is no guarantee of future results. 
US-domiciled mutual fund data is from the CRSP Survivor-Bias-Free US Mutual Fund Database, provided by the Center for Research in Security Prices, University of Chicago. 
 

 

The Costly Challenges Faced
Why do so many investors spend more than is warranted on their investments?

Obtaining true cost comparisons can be challenging to begin with. Some investment costs are easier to identify than others. For example, a mutual fund’s expense ratio must be clearly published in its prospectus. But in bond trading, there are hidden markups and markdowns, representing the spread between the “wholesale” price a broker pays versus the “retail” price for investors. Even an informed consumer isn’t currently privy to this information, although a regulatory Client Relationship Model currently being rolled out may change that.

It’s easy to misunderstand what you’re getting for the price. Even when data exists, it can be difficult to make heads or tails out of jargon-filled reports, so you can directly connect the full costs involved with the full expected return on your investment. You want to know, not just what an investment costs, but how those costs compare to other, comparable solutions. Only then can you reasonably assess whether you’re getting your money’s worth.

Advice That Pays
There is one investment that we do recommend to help you minimize your overall costs. Given the challenges involved, it pays to seek independent advice from a professional advisor whose fees are fully and transparently disclosed to you. Your advisor’s income should come only from you, for the objective advice being offered, with no additional commissions or other third-party incentives for recommending one fund over another. With the experience to guide you through the murky world of investment costs and the objectivity to represent your highest interests, such an advisor can be worth his or her weight in gold.

By: Nancy Graham with 0 comments.
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