Last week we talked about an important principle when it comes to investing: DIVERSIFICATION.
Today, we’re going to talk about something else that should also help guide you to successful investing.
Remember how we talked about Mutual Funds – those investment packages with a piece of several individual companies (or bonds) inside? Recall that instead of investing in each company individually, you can buy one mutual fund that holds most all of them.
Let me introduce one more term to you: an Exchange Traded Fund, or ETF. You don’t need to worry about the differences between or details of Mutual Funds or ETFs too much right now. Just know than an ETF is similar to a Mutual Fund in that it can hold many individual stocks and/or bonds within the one fund. (ETFs trade like stocks in real-time, unlike Mutual Funds.)
Here’s what you do need to know:
Mutual Funds and ETFs each have associated EXPENSE RATIOS.
There is a cost to owning Mutual Funds and ETFs, and this fee is called an EXPENSE RATIO. Basically, this is the fee that goes back to the “fund owner” and compensates them for managing the fund – which companies to buy, which to sell, how much of each to hold, that sort of thing. And when you own a mutual fund or ETF you pay this fee annually (though they just take it out – so you likely won’t notice it on an account statement).
The key here is that some funds have HIGH expense ratios and others have LOW expense ratios. And the high expense ratios don’t always (usually) indicate better funds!
Here’s how they work:
Imagine you own $1,000 of Mutual Fund A, which has an expense ratio of 1.30%. That means every year you are paying $1,000 x 1.30% = $13 to the mutual fund owner.
Now, imagine you could buy a similar mutual fund, Mutual Fund B, but this fund only has an expense ratio of 0.07%. This time you pay $1,000 x 0.07% = $0.70 back to the mutual fund company. That’s only 70 cents!
This makes a big difference and can really add up and contribute to the long-term growth of your investments.
If, for example, you invested in Mutual Fund A for all of last year and it returned 1.30% for the year, you wouldn’t make ANY money! All of the return would go back to the mutual fund. With Mutual Fund B, however, you would have earned 1.30% – 0.07% = 1.23% (assuming Mutual Fund B also returned 1.30%).
Your return is only what you make ABOVE the expense ratio! (Which explains why lower cost funds make for better investments – usually.)
Alright, let’s use some real examples to make sure you’re still with me:
The Oakmark International Fund (OAKIX) has an expense ratio of 0.95%. Another international stock fund, the Vanguard Total International Stock Index Fund (VTIAX) has an expense ratio of 0.12%. And in this case, the Vanguard fund is more diversified – owning 5,934 stocks while the Oakmark fund holds only 56. The less-expensive fund wins here! (In my opinion.)
Alright, so know that you have the basics down, what do you do about it?
First, if you have a 401(k) or 403(b), log in to your plan administrator’s website – where you can see your balance and all of that. Find the page where you can view all your investment options. Usually, all the available funds will be listed on one page and often the expense ratios are in a column on that page. If not, see if you can click on each fund and get more information to find the expense ratios.
Just notice the varying expense ratios. Which fund has the highest expense ratio? Which has the lowest? Make sure you’re not invested in any high expense ratio funds* – unless you have a really good reason to do so. BUT, at the same time, don’t forget about diversification! You don’t want to pick the fund with the lowest expense ratio and invest solely in that fund – especially if it’s a short-term bond fund.
Second, if you have other investment accounts, review the expense ratios of the funds you hold. You can go to Morningstar, type in the ticker symbol, and see the expenses.
Let me know if you have questions!
*A “high” expense ratio can be relative, especially depending on the options in your 401(k). If you can choose funds in the range of 0.00% – 0.60% I think that’s a great place to be! Expense ratios above 1.00% make me uncomfortable.