There's one thing you can control, and that's what you pay to be a part of the stock market, and that's where the expenses come in. When you buy a mutual fund, you always pay something for the right to have money in it. It may be a quarter of 1 percent, it may be 1 percent. If you are very unlucky and foolish, it's close to 2 percent. It's almost impossible for a fund manager to be such a great stock picker that he can make up for the money they're taking out of your fund to cover their expenses.
People have to watch out for loads, too. Loads are the sales charge that you pay a broker to help you pick a fund. If, for example, you were paying your broker 5.75 percent for a load fund, you would say to yourself, "Well, that's the cost to play, I might as well pay it; 5.75 percent doesn't sound like a big number." But if you were putting $10,000 into the fund, that would mean you were giving your broker $575 to pick that fund for you and that would mean you were putting $9,425 to work.
What about no-load funds?
Those would be like those index funds I've talked about. But even with index funds, if you buy them through a broker, you have to be careful because they might still charge you a load, even though the whole idea behind the index fund is to have a simple form of investment where you don't need advice, you can do it yourself and you shouldn't have to pay extra fees. The beauty of an index fund is simply that it's a low-cost fund. It mimics the whole stock market, so it's cheap because you're not paying anyone to try to outsmart the stock market. You're just taking what the market does for you, and that's usually better than if you pay a fund manager to try to be better than the stock market.
Do you recommend low-cost index funds if they are an option in a 401(k) or IRA?
Yes. Let's say a person put $10,000 into a low-cost fund that charges, let's say, 0.31 percent as an expense ratio, or one that just charges the average, the 1.4 percent. After 20 years, the low-cost fund would give you about $63,600 if you had a 10 percent average annual return. The more expensive fund that just charges 1.4 percent would give you about $52,000. You'd shortchange yourself about $12,000. That's why people tend to do better with index funds than with other funds, simply because that's a high hurdle for a manager to have to jump to make up for the extra fees that you're paying.
Incidentally, those fees that you're paying may be something people might not understand either. You pay the mutual fund company for everything from paying the fund manager's salary to advertising the fund so that they can get other customers. You pay for that.
“The beauty of an index fund is simply that it's a low-cost fund.”
Most people have never heard of the word "expense ratio," and it's such a simple thing to just look at one number and see, is it 1.4 percent, which is average but not good, or is it 1 percent, which is better, or is it 0.25 percent, which is a lot better? People don't have to do math to do that, they just have to look at it and say, "Is the number higher or lower? I want the lower number."If it's in the 401(k) plan, that's a different matter than if they're picking funds for an IRA. If you're picking your own funds for an IRA, doing the kind of analysis that I'm talking about is absolutely critical. If you have a 401(k) plan, it's a little more difficult. You can do the same analysis, but sometimes the numbers aren't as readily available, depending on how your employer chooses the funds for the plan. You can still go to the administrator for the plan. Usually you're given an 800 number and you could still call that 800 number and you could say, "I want to know what my expense ratio is on each mutual fund," and then you could compare them.