Next time you’re in a bookstore, take a look at the latest financial magazines on the newsstand. Flip one open to any page and, more than likely, you’ll see a full page ad for a mutual fund.
And prominently displayed next to the family running in the daisy field will be a box showing the 1, 3, and, if you’re lucky, 10 year returns for that mutual fund.
As you’re biting your nails trying to decide which mutual fund to invest in (my goodness, they’ve all performed so well over the last 80 years!), how do you reach a final decision? Which rate of return (1,3, or 10 year) gives you the best performance indicator? Turns out that none of the above should be your answer. Asking what a fund’s return isn’t the question you should be asking at all.
According to Fool.com,
If you were only able to ask one question about a mutual fund…the first question that you should answer before buying or deciding to continue to own a mutual fund is “What about the costs?”
These costs—in addition to any sales costs, or loads—are rolled into what’s called an expense ratio.
The expense ratio represents the percentage of the fund’s assets that go purely towards the expense of running the fund.
These costs include the fund manager’s salary, the fund manager’s administrative staff, overhead fees, etc.
So, if a mutual fund’s expense ratio is 1.5%, what does that mean? How does it affect my decision making?
With an expense ratio of 1.5%, a mutual fund is cutting itself in on 1.5% of the total money in the fund every year.
If you’ve been in the market at all lately, even if it’s a retirement account you never touch, you’ve been on a wild, roller coaster ride. Does the expense ratio adjust based on performance? That is, does the company charge less during poorer performing years? Nope. Not at all.
The fund continues skimming 1.5% of the fund’s total value in good, bad, or here recently, very ugly market conditions. Oh, you broke even or made a little money with a 1% return? Not so fast. You gave 1.5% of your money to keep the fund operating. How thoughtful and nice of you!
One other point you need to remember is that these costs will go up. Think about a lawyer, accountant, or doctor. Is it more or less expensive to visit one of these professionals today than 10 years ago? The costs to actively manage a fund will inevitably go up as well.
So, what’s the bottom line? Costs matter—tremendously. So don’t be foolish, visit Fool.com to learn how to be a better, and smarter, investor.