The Million Dollar Decision

The Million Dollar Decision

There a lot of money being made in the business
of money. I don’t think that’s a surprise to anybody, but do you really know how much
of your money may be being lost to the investments you choose to invest in? Now I’m not talking
about market crashes here, you only ever truly lose money during those if you have to sell
your investments during the crash. If you’re able to wait out the crash without selling
your investments, then the loss never makes it past the stage of just being “on paper.”
No, I’m talking about one number that’s attached to the mutual and index funds that
you’re invested in that could end up costing you half a million dollars or more over the
course of your life. And today we’re going to be talking about exactly what that number
is as well as what you can do to lower it in your own investments. Let’s
get started. So many of you have already probably guessed
what the number I’m referring to is. It’s the expense ratio of any mutual or index fund
in your portfolio. An expense ratio, sometimes also referred
to as the management expense ratio or the total expense ratio, for those who don’t
know, is basically a way of telling us how much of the mutual funds’ assets are used
for administrative and operating purposes. The percentage is calculated by taking the
costs to operate and maintain a mutual fund divided by the total amount of assets that
the fund has. The costs associated with operating the fund include paying for things like fees
that are paid to the fund’s investment manager or advisor, recordkeeping costs, custodial
services, legal fees, as well as taxes and other accounting service fees. So they are
absolutely necessary for us to have the options to invest in these funds, to begin with, but
it would be beneficial to all of us to keep an eye on them and keep them as low as reasonably
possible. Now I’ve talked about expense ratios a couple
of times before in some of my much older videos comparing passive and active investment options
because there’s usually quite a striking difference between how much money you’ll
effectively be paying to have most actively managed mutual funds as opposed to the more
passively managed index funds. But since those videos were made so long ago that many of
my newer viewers probably haven’t seen it (and since expense ratios weren’t really
the primary focus of those videos in the first place) I wanted to make a video dedicated
to them. So with that in mind, just how big of a difference is there when it comes to
investment performance and your future net worth if you invested in funds with high expense
ratios versus if you invested in funds with low expense ratios? As it turns out, there’s
quite a big difference. Let’s take a look. Let’s say that John and Jane invested in
a fund that charged absolutely no expenses whatsoever. They had $10,000 worth of savings to throw
in right away and after that, they invested $500 a month for 40 years and averaged returns
of 8% per year over that time. After those 40 years have passed and they’re ready to
retire they would’ve amassed a net worth of $2,000,000! In this perfect world, John
and Jane could live on about $80,000 a year in retirement plus anything that they may
have coming in from social security, pensions, side hustles, or other sources. Not bad, but
now let’s throw some expenses into the equation. As I’ve covered in previous videos, expense
ratios can vary, sometimes quite a bit, from one investment to another. A general rule
of thumb that many financial experts throw out there is that you should try to keep the
expense ratios of the funds in your portfolio under 1% if at all possible. And there are
many index and mutual funds that would fall under that limit, but not all of them do,
some go as high as 2% to 2.5%! So first let’s say that John and Jane decide
that they will invest in an index fund with an expense ratio of 0.04% which would be right
up there with the best rates in the industry as of this writing. They still have that $10,000 worth of savings
to invest right away and still continue to invest $500 a month over the course of 40
years and average a return of roughly 8% per year during that time. At the end of 40 years,
they would end up with a net worth, after adjusting for expenses, of about $1,975,000!
This means that, in comparison to a hypothetical fund that had absolutely no costs associated
with maintaining it, John and Jane spent about $25,000 over the course of 40 years to get
that 8% average annual rate of return. That averages out to about $625 a year or a little
over $50 a month, which may sound like a lot you have to remember that of that $1.975 million
that they had accumulated $1,725,000 of it was interest. They only invested $250,000
of their own money – that initial $10,000 and the $500 a month for 40 years. So, in‌
‌essence, they traded $50 a month to get the opportunity to invest in exchange for
what averages out to be nearly $3,600 a month in interest over the course of those 40 years. Pretty good if I do say so myself. And this
savings would allow them to have a decent income in retirement of a little under $80,000
a year according to the 4% rule, plus anything they may be getting from social security and
other sources if that’s still around by the time they reach retirement. But, as I said, not all investments have expense
ratios as low as 0.04% per year, most are quite a bit higher. You can usually find index
funds in the neighborhood of 0.1% to 0.3% per year and mutual funds often however somewhere
in between that 0.3% and 1% range with some being much higher. So what if, instead of investing in that incredibly
low-cost index fund, John and Jane instead invested in an active fund that had an expense
ratio of 1%? Assuming John and Jane still invested the
same amount of money over the same length of time and averaged that 8% return, they
would end up with a net worth, after expenses, of $1,483,175 after 40 years. This would enable
them to live on almost $60,000 a year in retirement through their nest egg using the 4% rule.
Still not bad, but definitely a significant difference from the low expense ratio fund. If we compare the low expense ratio fund to
the 1% expense fund we see that the difference between the ending net worth’s of the funds
was about $492,600 after 40 years. That averages out to a difference of approximately $12,300
a year or over $1,000 a month! In order to just break even on that difference, John and
Jane’s more expensive mutual fund would need to earn them an average rate of return
of nearly 9% per year over those 40 years. And the difference becomes even starker if
we look at some of the highly expensive mutual funds out there. For example, what if instead
of investing in either the low expense index fund or the mutual fund with the 1% expense
ratio, what if John and Jane invested in a more expensive fund that charged a 2% expense
ratio? Assuming all the other factors stayed the
same, John and Jane would end up with a net worth, after adjusting for expenses, of about
$1,110,300 after 40 years of investing. On the one hand, they still end up with over
a million-dollar nest egg, there are worse things in life, but that’s not the point
here. The point is that in comparison to the low-cost index fund that performed basically
the same in terms of return on your investment, the high-cost fund ends up costing John and
Jane an additional $865,500! That’s over $21,600 a year or roughly $1,800 a month. That one number is the difference between
John and Jane retiring and living on $80,000 a year and retiring to live on $44,000 a year.
That is absolutely insane! And, what’s worse is because of the effects of compound interest,
the difference would only get larger and larger the further down the line we go. For example, assuming an 8% return John and
Jane would earn over $157,000 in interest and appreciation on their investments in their
41st year of investing, after expenses, assuming they had the low-cost index fund. In that
same year with the high-cost fund they would only earn about $118,500 after expenses. That
means that in their 41st year of investing, despite getting a solid 8% return on their
investments before expenses, that high-cost fund is costing them $38,500 a year, in a
year that would quite possibly be their first in retirement. I know a lot of people today that are either
by choice or circumstance living on less than that $38,500 a year. Heck those who follow
the leanfire movement are aiming to, or already are, living on no more than $40,000 a year
in retirement. So this is quite a big difference. And as you can imagine, due to the effects
of compound interest, this difference becomes even more pronounced as your rates of return
get higher. An index fund like Vanguard’s S&P 500 index fund with a 0.04% expense ratio
that earns 10% per year for 40 years would have an ending net worth of $3,678,000! A
high-expense mutual fund with the same returns but a 2% expense ratio would have an ending
net worth of less than $2,000,000! That’s over a $1.5 million gap and it’s the difference
between an $80,000 a year income in retirement and a nearly $150,000 a year income in retirement. And while that may be true, it, of course,
isn’t the only factor to keep in mind when picking out which investments you want to
buy, I understand that so I don’t want to go and blow this whole thing out of proportion.
Because even the 2% expense ratio that the high-cost fund had in this video, may be worth
having over the long term if the return it gets is high enough. Say if that fund managed to average an 11%
annualized rate of return over those 40 years. In that case, John and Jane would end up with
a net worth, after adjusting for expenses, of $2,719,300 which of course is nearly $750,000
more than the low-cost index fund ended up having. Statistically speaking, particularly
in the large-cap space, it’s not exactly common to find funds that can actually pull
off beating their index by that much over a period of time as long as 40 years, but
that doesn’t mean that it’s it never happens. The key is to not overpay for what you’re
getting because over time it can make a huge difference.

12 thoughts on “The Million Dollar Decision

  1. Another great video. I'm glad you dedicated a video to expense ratios. It's something a lot of people don't even think about when they are choosing investments, especially when the options are so limited in cases like a company 401k. Definitely something to pay close attention to, but as you mentioned you kind of have to do the math to see how those higher expense ratio options have performed to figure out if it could be worth it. Sadly, as they say, past performance isn't an indicator of future success, but usually it's all we have. —- Oh, I also didn't realize how far into LeanFIRE I was. $40k/year??? My retirement years are forecasted to be about $23k/year and oddly enough it doesn't feel very spars or "lean" to me… It includes all of my necessities, a decent fun budget, emergency savings and some left over just in case. Funny what others consider lean, I consider plenty.

  2. I’m glad you covered this topic! I’m slowly reviewing various topics and this is one I need to understand. Next question is what and how to anticipate taxes and cost of living adjustments and how much will I need to offset in retirement. I also need to understand anticipate rate of return.
    I fear my husband’s investments were/are actively managed and costly. We will need to have a talk! You may save us thousands in the future Daniel.

  3. You do a great job of explaining difficult topics. Would you please break down stock options trading? (That is, if you understand it.)

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