Your Money_ The Missing Manual - J. D. Roth [129]
Altogether, mutual-fund costs typically run about 2% annually. So for every $1,000 you invest in mutual funds, $20 gets taken out of your return each year. This may not seem like much, but as you'll see in the next section, 2% is huge when it comes to investments. (For more on the importance of costs, see Keep Costs Low.)
Tip
To find how much your mutual fund is costing you, pull out the fund's prospectus. (If you can't find your copy, go to your fund company's website and download it.) For help deciphering the prospectus, check out http://tinyurl.com/GRS-prospectus.
With more than 10,000 mutual funds to choose from, how do you decide which one to buy? The costs of the different funds can help you narrow the field.
The way a fund is managed plays a big role in its costs. Mutual funds can be either actively or passively managed. Actively managed funds try to beat the market and earn above-average returns. Some succeed and some don't, but as a whole, all actively managed funds earn the market average. Passively managed funds (called index funds), on the other hand, try to match the performance of a specific benchmark, like the Dow Jones Industrial Average or S&P 500 stock-market indexes. As you'll learn in the next section, this makes them a great long-term investment.
Index funds
Because index funds try to match an index and not beat it, they don't require much intervention from the fund manager, which makes their costs much lower than those of actively managed funds. In The Little Book of Common Sense Investing (Wiley, 2007), John Bogle writes that the average actively managed fund has a total of about 2% in annual costs, whereas a typical passive index fund's costs are only about 0.25%.
Although this 1.75% difference in costs between actively and passively managed mutual funds may not seem like much, there's a growing body of research that says it makes a huge difference in long-term investment results. Other advantages of index funds include diversification (see Mutual Funds) and tax efficiency. And because index funds have a low turnover rate—as described on Mutual Funds—they don't generate as much tax liability.
Note
Exchange-traded funds (or ETFs) are basically index funds that you can buy and sell like stocks (instead of going through a mutual fund company). To learn more about the subtle differences between index funds and ETFs, head to http://tinyurl.com/YH-etfs.
In Unconventional Success: A Fundamental Approach to Personal Investment (Free Press, 2005), David Swensen writes, "Fully 95% of active investors lose to the passive alternative, dropping 3.8% per annum to the Vanguard 500 Index Fund results." In other words, people who own index funds have typically earned almost 4% more each year than those who own actively managed funds. (This long article offers a good summary of the arguments for using index funds: http://tinyurl.com/dowie-index.)
By owning index funds, you can beat the returns of nearly everyone you know. But to do this, you can't let yourself get caught up in classic investing mistakes like those described in the next section. The key to successful investing—whether you own index funds or not—is overcoming bad behavior.
Note
If you're a math whiz and want to see all the calculations and proofs behind why index funds do better than actively managed funds, pick up a copy of Bogle's book or take a look at this short (but dense) paper from Stanford professor William Sharpe: http://tinyurl.com/sharpe-rocks.
Being on Your Best Behavior
Investing isn't rocket science; it's easy to understand the methods for reaping good returns. The biggest barrier to making those methods work is human nature. Research shows that when it comes