“One one-thousandth of a dollar.” I said. “That’s not much is it?”
I handed his phone back to him. He’d handed it to me to show me how low the expense ratio of his indexed mutual fund was.
He pressed his lips together, holding back a smile.
“I guess it’s my engineering training coming out,” he explained. “We’re taught to keep a close eye on expenses and I’ve just always thought low expense ratios are important in my investments.”
Expense ratios are the charges mutual funds extract from investors to operate their funds. All other things being equal, the lower the better. But like cars, houses and brain surgery, all things are rarely, if ever, equal.
“No doubt lower expense ratios can be important in growing your wealth,” I agreed. “But what about all the other expenses. How are you managing those?”
He looked at me over his glasses with a puzzled look, then gazed down at this phone again to see if he’d missed a category on his mutual fund’s app. After he couldn’t find a mention of any more investment expenses, he looked up and said, “What are you talking about?”
“Well,” I said, “let’s say you want to invest $10,000 per year for 30 years. That’s $300,000 of your money you’d be putting into your investment. If you were fortunate enough to earn an average of 8% every year, you’d have about $1.2 million in a cost-free environment.”
“But,” I continued, “the environment is not cost free. For example, any mutual fund you use is going to have an expense ratio. The average expense ratio for mutual funds in America is between half a percent and 1 percent. But you’ve got one even lower than that…1 tenth of 1 percent! So, at the end of 30 years, you’d still have about $1.2 million.”
“So, I’m good,” he said triumphantly.
“I’m not quite done yet,” I continued. “Do you pay taxes?”
“Obviously,” he said. “If I didn’t, they’d put me in jail.”
“Right,” I agreed. “We don’t want that. So, don’t forget that when your mutual funds grow, you’ve got to pay taxes on that income and growth too. There are lots of moving parts to the taxation of a mutual fund, but if it all averages out to about 20% annually, that will knock your $1.2 million down to about $900,000.”
“Ever heard of inflation?” I asked.
“Of course,” he said. “What does that have to do with my investments?”
“Well, inflation acts as a sort of silent tax on your investments. Inflation causes your future dollars to have less buying power than they do today,” I said. “So, the fact that you are not spending those dollars today but putting them somewhere hoping to grow for the future, means that inflation will have a long-term impact on them.”
“Even if the rate of inflation averages only 1% over the next 30 years, that will still have a $300,000 impact on your spending power from those future dollars,” I explained.
My friend was looking like his lunch didn’t agree with him.
“But it’s not all bad news,” I offered. “If we have inflation, you’ll probably be earning more money over time, which gives you more money to save and invest.”
“Well, it looks like I’ll have to be saving more, if all these costs keep popping up,” my friend said glumly.
“And we haven’t really gotten into the real sweet spot for investor costs,” I continued. “All these go under the banner of what I call ‘Stupid Human Tricks,’” I offered.
“Like…” he asked.
“Like trying to time the market, or predict the direction of the market, or getting scared out of the market, or being in the market when you had no business being there. Or the worst stupid human trick of all…trying to do any of this without an overall financial plan. That’s like a rookie pilot taking off without a flight plan. It is highly unlikely to have a happy ending.”
“So, are you saying I shouldn’t be so worried about my expense ratios?” he asked.
“Not at all!” I said. “Just realize there are other, much bigger, alligators in the pond for you to worry about.”
“Make sure you pay attention to them too.”
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