The Little Book of Common Sense Investing

How Investment Costs Reduce Your Returns

Successful investing is rooted in the simple reality that businesses create wealth. When you own a share of corporate America, you benefit from its collective productivity and innovation, making equity investment a naturally winning game. However, many people turn this winning game into a losing one by trying to outsmart the market. The financial system is filled with middlemen—brokers, managers, and advisors—who charge fees for their services. While the market as a whole earns a specific return, investors as a group only receive that return minus the costs of playing the game.

Imagine a wealthy family called the Gotrocks who own every business in the country. At first, they simply collect all the profits and dividends, keeping 100 percent of the wealth generated. Problems start when "Helpers" convince family members they can outperform one another by trading stocks and hiring experts. The family begins paying commissions and management fees, which act like a leak in their bucket of wealth. The total pie stays the same size, but the family’s slice gets smaller as the Helpers take their cut.

These costs act like a tyranny of compounding that works against your wealth. A typical mutual fund might charge a 1.5 percent expense ratio, but hidden costs like portfolio turnover and sales charges can push the total yearly cost above 3 percent. While a 2 percent difference in returns seems minor in the short term, over several decades it becomes a massive chasm. Consider an investor who puts $10,000 into the market for 50 years. At an 8 percent return, that money would grow to nearly $470,000. But if fees reduce that return to 5.5 percent, the final total drops to only $145,000. The financial system confiscates 70 percent of the total return, even though the investor provided all the capital and took all the risk.

While investment performance fluctuates wildly, the cost of owning a fund remains remarkably steady. This is a permanent drag on your wealth. Furthermore, most managed funds are incredibly tax-inefficient because their managers trade stocks constantly, often holding a stock for only about a year. This hyperactive trading triggers frequent capital gains taxes that eat away at your wealth. By contrast, a low-turnover index fund can produce nearly double the after-tax wealth of a managed fund over several decades. A strange paradox even exists with dividends: index funds appear to have higher dividend taxes because they pass earnings to you, whereas active funds often show lower taxes only because their high fees consume the income before you ever see it. It is always better to receive the money and pay a small tax than to lose the entire dividend to management costs.