In my last “No Dumb Question” segment, we started exploring a smart question: “Nancy, how much are my investments really costing me?” Last time, I talked about two of the most significant direct costs of investing.
It’s too bad we couldn’t stop right there, but there also are indirect costs to consider. Even if they’re out of sight, they still end up out-of-pocket. In today’s “No Dumb Question,” I’ll talk about two of these: taxes and a fund’s internal trading costs.
If you’re like me, you’ll readily pay a premium price if it also gives you premium value. For example, I love my Callaway golf clubs. If I ever did go pro, I’d still be using them.
On the other hand, I’ll also buy in bulk at Food Basics when my three kids are home. There’s no reason to spend more at a shi-shi store for the endless supplies they require. What I will do, is cost-compare on some of the less-obvious details, like making sure a bigger box is actually a better deal.
So it goes with your investing. If every cost were clear, you could simply choose the cheapest holdings. Instead, there are often indirect costs too.
First, there’s taxes. Oh, taxes! I’ve seen plenty of people’s portfolios where their investments generated positive gross returns, only to end up greatly eroded after taxes are paid.
Besides taxes, remember how I mentioned in my last video that you can save on trading costs by trading less often? Same deal with trading within the funds you’re holding. How good is your fund manager at minimizing the costs of those underlying trades?
As complicated as your trading might be, it pales in comparison to your fund manager’s. As an individual investor, your trades don’t impact the market. But a major player like a fund manager can actually influence market pricing, which can cost you more, mid-trade.
To offer a rough analogy, it’s like tossing a minnow versus a whale into a pond. YOU can slip in and out of the market with relative ease. A whale has to be a lot more careful!
Because they won’t ever show up as bills to be paid, but they can have a big, big difference on your end investment returns.
How big? The results of a 2013 study in a 2013 Financial Analysts Journal looked at this very question. The study was entitled “Shedding Light on ‘Invisible’ Costs,” and I quote from it: “The authors found that funds’ annual trading costs are, on average, higher than their expense ratio and negatively affect performance.”
In other words, a fund manager’s trading costs and similar activities can set you back even more than its published expense ratios. That’s like going to the store and finding out that the tax on that pair of shoes you’re coveting is going to cost you more than the shoes. Even I would not buy them under those conditions.
Fortunately, there are ETFS and fund managers who excel at managing the costs of their trades. The advantages of their approach typically show up when you compare their long-term returns across a decade or more to other funds with similar make-ups. When there’s a solid reason behind why higher returns are happening — when it’s not just random luck — these are the sort of returns you can more comfortably hang your hat on.
So, again, one way to make the most of your investing is to be mindful of all the investment costs you incur along the way. Little costs add up … and one way or the other, you’re the one paying them.
I hope I’ve given you some good ideas for ways you can keep more of your investment returns in your own pocket. Let me know if you have questions about what we covered here, or anything else you have questions about.
