Advice from the index-fund mastermind
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Costs add up
That brings me to my next question. You've made the point time and again that costs dramatically impact investor returns. No-load funds are preferable to load funds, naturally, but how important is the expense ratio?

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Let's take the question a little bit differently, if I might. There are three costs that are involved in mutual funds. The one that we talk about the most and the one that is the easiest to calculate is the fund's expense ratio. That averages about 1.5 percent for an equity fund and about 1 percent for a bond fund. That's a heavy drain on your returns, unless the money manager has superior ability, which over the long term very few do. People look good in the short term and then they fade in the long term. Working with low-expense ratio funds -- as I call it, fishing in the low-cost pond -- is one way to make sure your returns are improved.

There's a second cost that we don't pay nearly as much attention to and which we don't quantify very often, and that's the impact of a sales commission -- if you buy a fund with a load. For example, if the load is 5 percent, which is the typical load today, and you hold the fund for five years, that has cost you 1 percent a year. If you hold it for 10 years, it's a half a percent a year. Think about three-quarters of 1 percent a year, the combination of those two, as cost No. 2 after the expense ratio.

The third cost is hidden, but we know it exists; we just don't know exactly how large it is. That's the portfolio turnover cost. Mutual funds turn over their portfolios at an astonishing rate, averaging about 100 percent per year. By my estimates, any fund that turns its portfolio over at that rate is costing you an extra 1 percent per year: a half percent to buy all those securities, including market impact costs, and a half percent to sell them. A 100 percent turnover means a billion-dollar fund buys a billion dollars' worth of stock and sells a billion. That's our definition of 100 percent, but that's $2 billion of transactions. You have to take into account that cost.

If you find lower-turnover funds, and very few funds turn over at lower than 30 percent per year, you're talking about not 1 percent per year, but about a three-tenths of 1 percent cost per year. In other words, the turnover rate with the decimal point moved over two places (0.003). So 100 percent turnover would cost 1 percent roughly. And a 30 percent turnover would cost three-tenths of 1 percent. So let's call it an average of seven-tenths of 1 percent per year for portfolio turnover.

So adding costs together, we have a 1.5 percent expense ratio, if you're paying a sales commission, another 0.7 percent on average for a seven-year holding period plus another 0.7 percent for turnover costs if you're average, so that adds up to roughly 3 percent. That's an astonishingly high cost and investors are almost oblivious to nearly all of it, but totally oblivious to the second and third costs. We've got to pay attention, or as we say in "Death of a Salesman," "Attention must be paid."

I usually estimate total costs at 2.5 percent; if someone wants to argue that's too high, say a minimum of 2 percent paid by the typical fund investor. If you don't like my estimates, knock them down a little bit.