Why Expenses Really Matter When It Comes to Your Investments

So, how exactly does an investment house make money?

Let’s use Vanguard as an example. You can go there, sign up for an investment account with them, and buy shares of one of their funds and they don’t charge you a fee for doing so. Your fund rises almost exactly with the stock market. A few years later, you sell those shares – again, with no fee for doing so – and pocket some profits.

Where does Vanguard make money in that picture?

They make money by charging expenses directly to the investment. Throughout the year, they withdraw a little bit of the value of the investment you’re holding and keep it for themselves.

Let’s say, for instance, that you own shares in a fund that has $10 billion in total assets. During the year, they might withdraw, say, $8 million from that fund to pay the employees, keep the servers running, and so on. All that you actually see is a very slight gradual downtick in the value of the investment. In fact, the expenses are usually charged so slowly that you barely notice the change…

But it’s a real change, and it can be very expensive.

Those withdrawals done by the investment house have to be disclosed to the investor and they’re almost always listed as an “expense ratio.” It’s the percentage of the annual assets that the company pulls out in a year in order to pay for all of those costs. In that example above, where the fund has a value of $10 billion and they take out $8 million a year for expenses, the fund would have an expense ratio of 0.08% – a pretty good ratio, I might add.

Expense ratios are one of the very first things that I look at when considering an investment, and in the remainder of this article, I’m going to show you why it’s so important.

A Baseline Investment Example

Let’s start off looking at a very basic investment example. Let’s say that a company offered an investment with a 7% annual return and 0% expenses. I’ll tell you this – if that fund existed in the real world, my money would be there in a heartbeat. It’s also a pretty good analogy for the long term stock market, as a 7% annual return over the long run is what most models predict for the future.

I decide to contribute $5,000 a year to that investment over the next 40 years. I start this year with $5,000 at the start of the year and repeat that for the next 39 years. What will I wind up with?

At the end of the tenth year, my balance will be $73,918.00.
At the end of the twentieth year, my balance will be $219,325.88.
At the end of the thirtieth year, my balance will be $505,365.21.
At the end of the fortieth year, my balance will be $1,068,047.85. Pretty sweet; I’m a millionaire.

Unfortunately, expense ratios are going to change this picture, and not in a good way.

Investment Example With 0.1% Expense Ratio

Let’s take the above example and slightly tweak it. Let’s add a 0.1% expense ratio to that fund. We’ll assume, for ease of calculation’s sake, that the expenses are withdrawn at the end of the year.

In this example, at the end of the tenth year, my balance would be $73,471.93. Compare that to the balance I would have with no expense ratio, $73,918.00. After ten years, a 0.1% expense ratio will have cost me $446.07.

At the end of the twentieth year, my balance in this example would be $216,563.51. Compare that to the balance I would have with no expense ratio, $219,325.88. After twenty years, a 0.1% expense ratio will have cost me $2,762.37.

At the end of the thirtieth year, my balance in this example would be $495,244.13. Compare that to the balance I would have with no expense ratio, $505,365.21. After thirty years, a 0.1% expense ratio will have cost me $10,121.08.

At the end of the fortieth year, my balance in this example would be $1,037,993.60. Compare that to the balance I would have with no expense ratio, $1,068,047.85. After forty years, a 0.1% expense ratio will have cost me $30,054.25. Ouch.

As you can see, even a tiny 0.1% expense ratio has rather large financial implications over the long haul. It shaves about 3% off of the overall total over a forty year stretch, which is enough to actually affect quality of living in retirement, at least a little.

Many Vanguard funds have an expense ratio in this ballpark, which is one of the big advantages of their investing strategy. By just following extremely simple strategies (buy everything, follow the average), Vanguard keeps the expenses low.

Investment Example With 0.5% Expense Ratio

If we bump things up to about 0.5%, we’re getting into the realm of some of the better mutual fund offerings from all sorts of different companies. These aren’t bad investments at all in the grander scheme of things. Let’s take a look.

Let’s use the original example – 7% annual return, 40 years, investments at the start of the year – and add a 0.5% expense ratio to that fund. We’ll assume, for ease of calculation’s sake, that the expenses are withdrawn at the end of the year.

In this example, at the end of the tenth year, my balance would be $71,715.88. Compare that to the balance I would have with no expense ratio, $73,918.00. After ten years, a 0.5% expense ratio will have cost me $2,202.12.

At the end of the twentieth year, my balance in this example would be $205,894.67. Compare that to the balance I would have with no expense ratio, $219,325.88. After twenty years, a 0.5% expense ratio will have cost me $13,431.21.

At the end of the thirtieth year, my balance in this example would be $456,940.20. Compare that to the balance I would have with no expense ratio, $505,365.21. After thirty years, a 0.5% expense ratio will have cost me $48,425.01.

At the end of the fortieth year, my balance in this example would be $926,640.74. Compare that to the balance I would have with no expense ratio, $1,068,047.85. After forty years, a 0.5% expense ratio will have cost me $141,407.11. Wow.

At a 0.5% expense ratio, retirement savings are taking a major hit, big enough to change one’s long term plans significantly. About 14% of the balance has dissipated due to that expense ratio, which is going to seriously alter your plans.

But it’s going to get more painful yet.

Investment Example With 1.0% Expense Ratio

At a 1.0% expense ratio, you’re looking at investments that are perhaps a bit more pricy. Usually, these are heavily promoted “prestige” funds from investment houses.

Let’s continue to stick with the original example – 7% annual return, 40 years, investments at the start of the year – and add a 1% expense ratio to that fund this time. We’ll again assume, for ease of calculation’s sake, that the expenses are withdrawn at the end of the year.

In this example, at the end of the tenth year, my balance would be $69,583.01. Compare that to the balance I would have with no expense ratio, $73,918.00. After ten years, a 1% expense ratio will have cost me $4,334.99.

At the end of the twentieth year, my balance in this example would be $193,375.10. Compare that to the balance I would have with no expense ratio, $219,325.88. After twenty years, a 1% expense ratio will have cost me $25,950.78.

At the end of the thirtieth year, my balance in this example would be $413,608.23. Compare that to the balance I would have with no expense ratio, $505,365.21. After thirty years, a 1% expense ratio will have cost me $91,756.98.

At the end of the fortieth year, my balance in this example would be $805,415.39. Compare that to the balance I would have with no expense ratio, $1,068,047.85. After forty years, a 1% expense ratio will have cost me $262,632.46.

In that situation, you’re probably not retiring when you originally planned to retire – it’s simply not going to work out. The expenses have drained literally a quarter of your retirement savings at this point, which means that your annual withdrawal is going to drop by a quarter, too (unless you want to risk running out of money). You’re either going to be working for quite a few more years or you’re going to have a part time job in retirement or you’re going to have to accept a lower standard of living. That’s the reality of it.

But it gets worse yet!

Investment Example With 1.5% Expense Ratio

When you start getting above a 1% expense ratio, you’re usually in the domain of investments that are being heavily promoted by investment advisors that are getting a cut out of those expenses. I personally wouldn’t touch these with a ten foot pole, but they’re out there. Let’s see how painful they are.

Let’s continue to stick with the original example – 7% annual return, 40 years, investments at the start of the year – and add a 1% expense ratio to that fund this time. We’ll again assume, for ease of calculation’s sake, that the expenses are withdrawn at the end of the year.

In this example, at the end of the tenth year, my balance would be $67,517.26. Compare that to the balance I would have with no expense ratio, $73,918.00. After ten years, a 1.5% expense ratio will have cost me $6,400.74.

At the end of the twentieth year, my balance in this example would be $181,703.79. Compare that to the balance I would have with no expense ratio, $219,325.88. After twenty years, a 1.5% expense ratio will have cost me $37,622.09.

At the end of the thirtieth year, my balance in this example would be $374,818.33. Compare that to the balance I would have with no expense ratio, $505,365.21. After thirty years, a 1.5% expense ratio will have cost me $130,546.88.

At the end of the fortieth year, my balance in this example would be $701,417.47. Compare that to the balance I would have with no expense ratio, $1,068,047.85. After forty years, a 1.5% expense ratio will have cost me $366,630.38.

There you have it. At the forty year mark in a 1.5% expense ratio investment, a full third of your money is gone to expenses. Poof. You may not even be able to retire at all at that point.

The Impact of Returns Versus Expense Ratios

As you might be able to guess, there’s a bit of tension between annual returns and expense ratios. A fund that has a higher annual return than another fund can get away with a somewhat higher expense ratio and still be beneficial for you as a customer. The trick, of course, is to find that fund that actually has a long-term history of a higher annual return.

Let’s look at the numbers to see how that works.

An 8% Baseline Investment?

For this example, let’s tweak the baseline investment from earlier. We’re still investing $5,000 a year, but now it has an 8% annual return, over 40 years, with a 0% expense ratio.

In that case, at the forty year mark, your investment would be worth $1,398,905.20. Remember, in the initial example, the annual return was 7% and we wound up with $1,068,047.85. So, just by bumping the return up from 7% to 8%, we increased our total return by $330,857.35.

If we toss in a 0.1% expense ratio, our forty year total goes down to $1,358,375.12, a loss of $40,530.08 compared to no expense ratio.

If we use a 0.5% expense ratio, our forty year total goes down to $1,208,392.96, a loss of $190,512.24 compared to no expense ratio.

Now, here’s where it gets interesting. If we use a 1% expense ratio (with the expenses removed at the end of the year), our forty year total drops to $1,045,489.98, a loss of $353,415.22 compared to no expense ratio. Why is this one interesting? This is the point where the return is actually lower than a 7% investment with 0% expense ratio, which would give us $1,068,047.85. Part of that comes from exactly when the expenses are withdrawn throughout the year and when the returns come in throughout the year, of course.

If you have a 1.5% expense ratio, your year-end balance is $906,114.04, which is again somewhat comparable to a 7% annual return with 0.5% expenses, which would give you $926,640.74.

The Impact of Expense Ratios

To summarize all of this, what you’ll notice is that the annual return of a mutual fund or index fund minus the expense ratio gives you a good idea of what your annual return will be for that investment. It’s not a perfect result because it varies depending on when the expenses are withdrawn and so on, but it will get you fairly close to the right number.

However, when in doubt, go for the fund that has the lower expense ratio. So, if you’re looking at two investments, when one has a 7% annual return and a 0.5% ratio and the other has an 8% return and a 1.5% ratio, you’re better off with the lower return and drastically lower expenses.

That’s because, year in and year out, the annual returns are going to jump up and down, but the expense ratio is going to stay the same. Thus, in a bad year, the expense ratio becomes increasingly more important and a high expense ratio is really going to pinch you badly, choking off the returns. You gain some of that back in the good years, but in a volatile investment, it’s generally not quite enough.

How Can You Find Out Expense Ratios

When you’re choosing between investments of a similar type, two pieces of information you’re going to want to know are the average annual return and the expense ratio. Both of those numbers should be easily available in the summary of an investment; if they’re not, tools like Yahoo Finance or Morningstar will help you quickly find that data.

As I mentioned above, the simplest way to use that information is to take the average annual return and then subtract the expense ratio from that, then use that number to compare different funds. If they’re pretty close, go with the one that has the lower expense ratio; if they’re still really close, go with the one that has the longer history.

Final Thoughts

Expense ratios are extremely important when you’re investing. As you’ve seen, a bad expense ratio can gobble up a lot of your money over the long haul. While you’re almost always going to have to settle for at least a small expense ratio, there’s a world of difference between a 0.1% expense ratio and a 1.5% expense ratio. Over the course of many years saving for retirement, the difference is hundreds of thousands of dollars.

Another important thing to remember: expense ratios and annual returns aren’t the only thing you should be considering while investing. You should also be considering risk, which you can figure out by looking at the annual returns each year for the last several years. Do those jump up and down a lot? Such investments are fine for the very long term – more than ten years out – but as you get closer to your goal, you’re going to want investments that don’t jump up and down each year, even if that means a lower average annual return. That’s because you don’t want to hit your deadline at the end of a very bad year because that will really hinder you going forward.

Expense ratios are mostly useful for comparing very similar investments, ones with similar rates of return and similar volatility. When I’m looking at investments like that, expense ratios are almost always the tiebreaker. I virtually always go for the investment with the lower expense ratio.

So far, using this strategy seems to have worked well for my family. We have most of our long term savings and investments with Vanguard in investments with very low expense ratios that strive to simply match the market by owning a little bit of everything. That strategy has worked like a champ, and low expense ratios are a big part of the reason why.

Good luck!

The post Why Expenses Really Matter When It Comes to Your Investments appeared first on The Simple Dollar.