The Smartest 401(k) Book You'll Ever Read

Retirement savings by learning how to avoid the minefields planted by the securities and insurance industries to explode your nest egg. Let's start the process of converting your pig of a plan into the swan you deserve. What's the point? You can make your retirement plan work for you. Chapter 2 Small Change Can Break the Bank It will come as no surprise to anyone who has seriously studied investment returns that cost matters. In fact, the funds in the group with the lowest expense ratios had the highest net returns. John C. Bogle, Common Sense on Mutual Funds If you only remember one cardinal rule about investing, this is it. Lower costs directly relate to higher returns. Let's start by comparing the costs of different types of mutual funds. What do I mean by costs? I'm referring to the expenses an investor is charged by a mutual fund, the percentage of a fund's assets that investors pay to offset the expense of running the fund. This is the cost of the fund. High expense ratios are bad. Low expense ratios are good. I focus on mutual funds because, as you will see, mutual funds are the investment of choice for most investors in both retirement and non-retirement accounts. If your child earned a 98% on his math test, you'd probably be thrilled. And what if he earned a 96%? You wouldn't be any less happy. An A is an A. Such a tiny difference won't matter if you're a fourth grader, but these seemingly inconsequential percentage point differences can make a tremendous difference to just about anybody who invests. A two percentage point difference in expense, even 1% or less in a portfolio, can seriously deplete your assets over time. Here's a simple example. A young college graduate begins investing $200 a month in mutual funds until she retires 40 years later. She earns an 8% annual return, before expenses, on this money, and her mutual fund of choice charges her 2% annually in expenses for all those many years. At the end of the line, she walks away with $400,290. That may look respectable, but check out what she would have earned if she had put the cash in a mutual fund at a fraction of the cost, let's say 0.3%, an expense ratio similar to what is charged by many index mutual funds. If she'd done that and obtained the same returns, which is likely, her account would be worth $644,484. Yet if someone tried to sell the typical investor a mutual fund that costs 2% of the investment versus 0.3%, most people would consider the difference to be about as inconsequential as the change you get back from a McDonald's Happy Meal. But it's not inconsequential. That small percentage difference can make a huge impact on your retirement savings. And the more money you've got squirreled away, the more painful a voracious funds incisors will be. Suppose someone has $1 million in assets parked in a portfolio that earns 8% annual return, but chews up 2% of its value every year in expenses. The investor feeds another $1,000 into the account each month for 20 years. At the end, the account balance would be $3,774,556. Nice, right? But wait. If our millionaire had invested in funds with expenses kept at 0.3%, the ending balance, again assuming the same returns, would be $5,212,877. That's a stunning difference of $1,438,321. And he earned this without having to work on weekends or make any other financial sacrifices. He just had to pick a dirt-cheap index fund. These possibilities make the investment world break out in hives. The people who sell stocks, bonds, mutual funds and annuities would rather we all invest blindfolded, oblivious to the huge differences that costs make in our portfolios, because these higher costs provide them with higher commissions. And it is fairly easy for them to get away with this charade. After all, aren't we conditioned to believe that the more expensive the product, the better it is?