Even those investors who go it alone, buying and selling individual stocks and bond will see costs quickly mount, especially if the size of an investor's investment account is modest or her trading costs are high. An investor with a $20,000 trading account, making twenty $10 trades a year, will see 1% of her investments eaten up in trading costs alone, not including any additional account fees.
Investors who purchase investments via their 401(k)s and 403(b)s will also incur similar investment costs. Unfortunately, the transparency of such retirement accounts is lacking to such an extent that in a recent AARP survey 83% of 401(k) investors didn't know how much they were paying in fees and expenses for their 401(k). More than seven in ten (71%) claimed they paid no investment costs in their respective 401(k), although nearly all of these investors are assessed such costs.
These costs also add up to lower returns for investors. Morningstar compared five mutual fund categories – U.S. stocks, International stocks, "Balanced" funds, Taxable bond funds, and Municipal bond funds – and compared their performance over 5 years based on their respective expense ratios. They found that the least expensive funds, those in the lowest quintile of expenses, outperformed the highest costs funds in every category and in every time period, from one-year to five-year (see chart below).
Below I compared two hypothetical mutual fund investors. One invests in a low-cost, low-turnover index stock mutual fund, the other in a traditional actively-managed stock mutual fund with higher costs. In this example, the yearly cost difference between the funds is 1.6%. Compared to the stock market's 9.0% cost (in this hypothetical example, with consistent, though unrealistic, yearly returns), the 1.6% yearly cost difference doesn't seem excessive. However, we see that over long periods, the difference in costs add up to big differences in wealth accumulation.
Investment costs matter. And they're one of the primary reasons why investors as a whole have not been particularly successful investors. We'll look at this more next time.