The Most Expensive Isn’t Always the Best

When it comes to investing, some of the best investor behavior seems counterintuitive:

  • Buy when everyone else is selling
  • Don’t buy when everyone else is buying
  • Paying more doesn’t mean doing better

The first two pieces of advice may sound familiar. They’re favorites of Warren Buffett. The last piece of advice is one of my favorites, in large part because the data is so clear.

For instance, the research shows that what an investor pays to invest in a mutual fund (e.g., the expense ratio) is one of the few predictors of its future performance. In what seems like a huge contradiction, the more you pay, the greater the odds that a mutual fund will underperform.

Morningstar took a look at fund performance in broad U.S. equity group funds from 2008-2013 and found that “the higher the fees, the less likely funds were to survive and outperform.” The data also showed similar results “in the sector-equity, international-equity, taxable-bond, and municipal-bond groups.” As you can see from the chart below, the least expensive funds were almost twice as likely as the most expensive funds to survive and outperform. That’s a huge difference for investors!

On top of underperforming, every additional dollar you spend on fees is one less dollar you get to count in your returns. When you throw in compound interest, what may seem like a small fee in the beginning begins to cost you a lot over time.

I’m highlighting this issue because it’s easy for investors to skip this particular investment math. It just doesn’t feel like a big deal. But what if failing to do the math ends up costing you money?

Let’s assume you have $1 million, and you’re presented with two investment options. Both options are promising a gross return of 9% over 20 years. But there’s a catch. After fees, option one will net you 8.5% and option two will net you 7.5%. A 1% difference isn’t a big deal, right? Over 20 years, if you net 7.5% on $1 million you’ll earn $4,247,851. That’s a nice nest egg. But if you net 8.5% on your investment, you’ll earn $5,112,046, almost $1 million more ($864,195.02 more to be exact). That 1% added up to quite a bit.

Sometimes it’s worth it to pay for the most expensive option. But when it comes to investing, opting for the less expensive option is likely to earn you much more and cost you much less.

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