Investing can be really confusing. That’s why when most of us open a 401(k), Roth IRA, or a basic investment account, we often let the “experts” handle the details. We pick one of the investment plans the company suggests, or we just hire a money manager to invest for us.
But the truth is, more often than not, this can cost us heavily. Read on to learn how you can double your savings when you retire with one simple action …
- What Are Mutual Funds and Index Funds?
- Well-Kept Secrets
- Twice the Retirement Savings: An Example
- Which Low-Cost Index Fund to Invest In
- Final Words
What Are Mutual Funds and Index Funds?
A mutual fund is a portfolio of investments that pools many individuals’ money together to purchase stocks, bonds, and other kinds of financial instruments in hopes that the value of these assets will increase and produce a profit. In comparison to investing in, for example, one particular stock, a mutual fund allows you to lower your risk because investments are spread out, or diversified, among different securities.
Mutual funds are run by money managers who, in selling and buying these different securities, attempt to produce gains for the fund’s investors.
An index fund is a type of mutual fund designed to replicate or track a specific part of the financial market, like tech or even the American market as a whole. While other mutual funds are considered a more “active” form of investing with money managers moving assets around, index funds are more passive, allowing your investments to follow the movement of the market. Because of this, index funds don’t need to be actively managed by a financial expert.
Well-Kept Secrets
There are a few things that everyone should know about investing and mutual funds, but few actually do.
Money Managers Don’t Know Any More Than You Do
The first thing to know is that according to the data, the vast majority of actively managed mutual funds underperform in comparison to the S&P 500 index, often seen as a gauge of the entire market itself. In fact, only 10% of these funds outperformed the S&P 500 over the past 15 years.
In other words, these people can’t predict the market any better than you can. Nine times out of ten, you’re better off just putting your money in an index fund representing the market as a whole (for example one that tracks the S&P 500), than having someone handpick specific investments for you.
Many Mutual Funds Charge You A Lot of Money You Don’t Know About
There are two very specific charges you’ll likely find associated with your mutual funds, and they’ll often go unnoticed in small print:
- Financial advisor fees (could be labeled differently)
- Expense ratio fees
Now, you may not have directly hired a financial advisor, but if you’ve invested in an actively managed portfolio through your retirement or investment account, you’re paying a team of fund managers to make investing decisions. These fees can range from 0.25 to 3%, but a 1% fee is common. This may seem insignificant, but we’ll soon explain why this is not the case.
Expense ratios cover the operating costs of index and mutual funds — primarily the costs to buy or sell different securities (these will be much lower with index funds as there’s less trading activity). According to Investopedia, the average expense ratio for an actively managed mutual fund ranges between 0.5 to 1%, but can go as high as 2.5%. Again, these percentages may seem small, but their effects can be catastrophic to your savings.
The Implications
Because 1.) mutual funds managed by “experts” perform definitively worse than the overall market, and 2.) it costs much more to invest in these mutual funds than total market index funds (which generally give you higher returns), it tends to be a good idea to cut out the middleman and invest directly in the market through low-cost index funds.
Twice The Retirement Savings: An Example
The organization ChooseFI is a big proponent of the index fund VTSAX because:
- It tracks the total U.S. market
- There is no financial advisor fee
- Its expense ratio fee is 0.04%
ChooseFI created an illustrative example to show how you could end up with twice the retirement savings if you opt out of mutual fund investing in favor of low-cost index funds (or end up with half the savings if you don’t).
In their example, someone starting with $100,000 plans to invest for 40 years, with no further contributions. ChooseFI assumes a historically-based, conservative 8% gross stock market return.
The Low-Cost Index Funds Route
In their first scenario, the person decides to invest their money in VTSAX and just let it sit. Assuming that 8% average annual return minus the 0.05% annual fee (since the time of this example, the fee dropped even lower to 0.04%), after 40 years, their investment would be worth:
$2,132,582
The Mutual Fund With Financial Advisor Fees Route
They also present a scenario in which someone decides to go the mutual fund route. In their example, the financial advisor attached to the fund charges 1% and the mutual fund has an additional expense ratio of 1%, both common rates. Now you’re looking at an annual return of 6% (8% – 1% – 1%) rather than 7.95%. Seems minor, right? Well at the end of that 40 years — assuming that the money manager’s decisions didn’t put them at an active disadvantage relative to the overall market — this person’s investment would be worth:
$1,028,571
How’s this possible? It’s only 2% per year. The truth is that because of the compounding effect of that fee, it eats away at your investments, year after year. This math works out the same way whether you have $100 to start with, or $100,000. The mutual fund with net fees of 2% will leave you with half the savings as the low-cost index fund.
Use this investment calculator to see how much you might save with each of the funds.
Which Low-Cost Index Fund to Invest In
Now, your 401(k) or investment account may not give you access to the VTSAX index fund. That’s OK! Most retirement and investment accounts will have low-cost index funds that are close equivalents to VTSAX, also representative of the whole market.
Fidelity offers FXAIX which has an expense ratio of 0.015% and Schwab offers SWPPX with an expense ratio of 0.02%. If you do your research (and read the fine print about fees), you should be able to find a similarly affordable fund that, in tracking a vast diversity of companies across the U.S. (or world), protects you from the minor movements of the market.
Tommy Gallagher, ex-investment banker and founder of Top Mobile Banks, says that low-cost index funds are “an ideal choice for those who are risk-averse, as they automatically rebalance the portfolio over time and protect against the risk of individual stock and sector losses.”
While it may seem scary to put all of your savings into what seems like a highly volatile market without the “supervision” of a financial expert, that volatility is really limited to the short term. Crashes, while terrifying, happen, and then the market rebounds. In the long term, the market has always continued to go up.
If you’re a long-term investor like the person in the example above, simply interested in saving up for retirement or for your kids’ inheritance, know that investing in the stock market as a whole through a low-cost index fund has historically been a really smart play.
Final Words
Many people have no idea of the devastating effect that those seemingly small mutual fund fees can have on their investments, but it really can mean the difference between $250,000 and $500,000 savings.
In the end, taking just an hour or so to investigate where your money is currently invested, and making a slight adjustment to move that money into one or more low-cost index funds can make a huge difference to your future retirement and your financial legacy as a whole.
The information provided in this article is not intended to constitute specific legal, tax or financial advice. Instead, all information, content and materials available are for general informational purposes only. You should consult a legal, tax or financial professional with respect to your particular situation and circumstance.