Cost Management: A Timeless Investment Strategy for Turbulent Times

In preparing today’s article, I was reviewing my library of past articles. Two things struck me:

First, while the names and dates are forever changing, some combination of financial, economic or political crisis seems to forever be occupying our immediate attention.

Second, regardless of the particular crises faced, several timeless investment strategies shine through as best practices for surviving them.

Among the greatest of these timeless strategies is cost management, or doing everything you can to identify and control the costs you incur while investing.

Why Care About Costs?

So, what are our current crises?

To summarize, we face an impending presidential election; a fiscal cliff to be resolved — or not — by a lame-duck Congress; and uncertain effects of the Federal Reserve’s recently announced additional round of quantitative easing (QE3). That’s only considering domestic challenges, let alone continued global unrest.

As you consider how to position your portfolio amidst the turbulence, you may be tempted to ignore seemingly “trivial” investment fees, figuring you can do better by placing increased, well-timed trades in reaction to breaking headline news. There are three reasons you’re better off focusing on costs than on current events, at least as far as your investment strategy is concerned:

  1. You have no control over short-term market volatility
  2. You have a great deal of control over costs
  3. Those costs can really add up over time

Let’s explore each of these concepts in turn.

Market Returns and Investor Discipline

An overwhelming body of academic evidence has helped us understand how market pricing occurs and how essentially unpredictable it is. Because market prices are determined when the next piece of unknowable news is better or worse than expected, it stands to reason that current news, no matter how delightful or frightening, offers little insight on future pricing.

In fact, attempts to figure out the market’s next moves distracts us from our investment essentials: steadfastly maintaining a globally diversified portfolio of low-cost mutual funds designed to capture expected long-term market returns in accordance with your individual goals and risk tolerances.

This type of disciplined buy, hold and rebalance strategy may not sound as flashy. It lacks that “at least I’m doing something” appeal. But at the end of a volatile day (or few), it’s how patient investors are expected to earn durable market returns over time.

To provide a recent illustration, many investors who have been focusing on recent news and assuming the worst, may be unaware that stock markets have actually been performing quite well this year.

In his mid-September CBS MoneyWatch blog post, “Investors Worry While Markets Rally,” financial author Larry Swedroe observed,

“Despite all the negative news, the year-to-date returns on all of the major U.S. equity asset classes are much higher than their historical annual averages. And defying all the so-called experts, stocks around the world have provided double-digit returns as well. In short, investors scared by the headlines missed out on these strong returns.”

What’s a One Percent Expense Between Friends?

Thus, while you have little control over the games markets play, you can exercise a great deal of control over your costs to participate.

First, let’s address how important those costs can be. Expense ratios and other investment costs may seem small — mere single-digit percentages or less — but over time, they can add up in a big way.

To offer one example, imagine a $50,000 investment earning 8 percent annually for 20 years. If the expense ratio is 0.3 percent, the investment grows to $109,748. If you add just 1 percent for an expense ratio of 1.3 percent, the investment only grows to $89,997. That’s nearly $20,000 lost to the cost of investing. I’ll bet you can think of better things to do with that money!

The Costs Involved

Returning to your ability to control these costs, knowledge is empowerment, with essential education as your best defense. By understanding the costs involved, you can better identify when they’re unreasonable and make adjustments accordingly. Following are some of the biggest costs incurred.

Expense ratios and 12b-1 fees

In my previous illustration of costs, I mentioned expense ratios. What the heck is an expense ratio???

The expense ratio represents the costs to manage and advertise a mutual fund. It’s the cost you’ll see published in a mutual fund’s prospectus, if you have the stamina to read the fine print therein.

According to data and classifications provided by Morningstar, average annual expense ratios were 1.35% for all actively managed U.S. funds and 1.55 percent for all actively managed international funds as of August 21, 2012.

Expense ratios also include something known as 12b-1 fees, which were sanctioned by the SEC in 1980. This is the advertising portion of the expense ratio. It is limited to 1 percent by law, but we just saw what a big difference that 1 percent can make to your net results.

Brokerage fees

Trades completed within a mutual fund you’re holding show up in the aforementioned expense ratios, which is why it warrants paying attention to what those expense ratios are. In addition, your own trades are subject to brokerage fees whenever you buy or sell shares in your own portfolio. They place an additional unnecessary drag on your returns should you indulge in hyperactive trading.

So, what’s the difference between hyperactive and judicious trading?

My rule of thumb is to avoid trades that are in reaction to or anticipation of near-term events. Odds are, you won’t guess correctly often enough to overcome the costs involved.

Instead, trade when broad market events or your own wealth circumstances cause your portfolio to become misaligned with your carefully crafted Investment Policy Statement. Under these circumstances, you’re trading judiciously, according to your individual long-term goals rather than random short-term noise.

Trading costs

Trades also are subject to other, more elusive costs that eat away at your returns. Whether investing in mutual funds or directly in securities (stocks and bonds), you ultimately end up paying these costs in one form or another.

These can include the impact of turnover, tax inefficiency and holding an excessive amount of cash. Turnover is a function of a fund manager actively trading stocks within a fund in an attempt to outperform the market.

Tax inefficiency is a result of trading volume as well. The cost here is the drain on your return when interest, dividends and capital gains generate taxes that could have been avoided. Excessive cash means all the fund dollars are not invested and hence, not earning market returns.

As with brokerage fees, many of these trading expenses are exasperated by unnecessary, overly active trading as described above. Seeking passively managed funds and adopting a passive strategy with respect to your own trading helps minimize these sorts of costs as well.


Some other fees commonly paid but not very well understood are “loads” or sales charges. Sometimes you pay the loads upfront, when you first invest; sometimes they’re paid back-end, when you go to sell, or along the way while you hold them.

One way or another, those loads will cost you. Thankfully, in recent years, it seems investors have grown increasingly aware that there are plenty of sensible no-load fund choices available, and have been shifting toward them, as described in a 2012 Investment Company Fact Book published by the Investment Company Institute. Still, it remains a buyer-beware world out there.

Caveat Emptor Investing (and Seeking Expert Advice)

So, how do you minimize all these expenses?

You have to do your homework.

Most mutual funds are monitored by Morningstar, a service that rates funds and gives information about the make-up of the fund (such as large or small stocks, growth or value).

The expense ratio, along with any loads or 12b-1 fees, is reported along with performance and other important data like the fund’s turnover ratio (which is correlated to expected management costs).

As painful as it may be, you’re also well advised to review those prospectuses that fund companies are required to provide you. At least take a look at the published expense ratios there.

Beyond conducting your own due diligence on fund costs, the right type of investment advisor — one who works on a fee-only basis and in a clearly stated fiduciary relationship with you — can add significant value to your cost management efforts.

Consider the right advisor’s role similar to the value you add in a patient-doctor relationship. While taking vitamins and flossing daily are wise, do-it-yourself habits that anyone can perform, attempting to treat serious sickness or injury without expert counsel could clearly be penny wise and pound foolish.