31 August 2008
I grew up in an entrepreneurial household with a father who always preached about hiring the small business owner to do what they were good at. “Never change your own oil,” he would say. And he lived it as he would always pay up for quality work. Yet he always differentiated between paying for service, and simply wasting money on an inferior product. In a weak market like we are in, this advice is even more apropos.
When returns on investment are weak, you can only control your returns in one way – make sure you pay less since you get to keep what you do not pay for. Obvious, but based on what we see, often ignored. First some math – your return on an investment is the gross return (and this year that might be negative) minus inflation, minus taxes and minus expenses. Taxes can be controlled somewhat but that is for a future newsletter. Expenses are the big controllable issue in that equation. And if you think about it, expenses in a weak market are more important to watch. Ignoring negative returns since that is never good, suppose you ended the year with a positive return of 2%. If you have a mutual fund with expenses that are just .5% higher than a similar fund (with similar returns), then your return would be only 1.5%, or 25% less! In reality we see portfolios every day that have expenses much higher than that difference.
There are many things you can do to reduce your costs, and thus increase what you keep. For example, do not pay a commission on a 529 plan for your children/grandchildren’s education fund when most states allow you to purchase direct from the state with no commissions. Or look into what share class of a fund you are purchasing since most fund companies have a higher expense version and a lower expense version. And be wary of buying higher cost investments under the guise of tax savings or guaranteed returns (annuities, insurance). Even push this cost issue with your employer since many 401(k) plans are invested in higher costing funds or even group annuities when they need not be.
But one note of caution, do not throw the baby out with the bath water by never seeking advice. A good financial advisor is worth their weight in gold simply by steering you through bad times, much less good times. Instead, ask questions about the way you are paying expenses so that you understand how they are paid and the impact their expense plus the underlying investment expenses add up. In general, if total portfolio/relationship expenses are under 1.5% to 1.7%, you probably have a pretty efficient relationship with an advisor and they are probably recommending investments with fair cost structures.
Sometimes the boring but simplistic things in life make for the soundest strategies. And in thisücase, it allows us to keep more of what we make.