Observations: Real World Expenses Reduce Published Market Returns

The stock market returns published in this blog, and in most other publications, are theoretical returns. In the real world, investors incur expenses that reduce the reported market returns. This post overviews those expenses and shows how they can easily reduce a retirement portfolio to less than 50% of its theoretical value!

Graph shows costs reduce ROI of stock investments

Market or Index Returns

Elsewhere on this site, we have seen that over long periods of time, the DJIA (Dow Jones Industrial Average) has returned about 10% per year. For example, the return from year-end 1990 to year-end 2010 was 10.2%. That was the return earned by the market, as represented by the Dow index, reinvesting all dividends, and ignoring all expenses -- including taxes. Unfortunately, partly because of expenses, those returns do not accurately reflect the experience of the typical investor.

Investor Expenses: Taxes

Probably the most obvious expense that real investors have that theoretical portfolios do not have is taxes. Tax rates range from a low of 5% or less on taxable capital gains for taxpayers in the lowest income bracket, to a current maximum of 35% on taxable dividend income for taxpayers in the highest bracket. Thus, taxes can have a huge impact on the actual returns of investments held in taxable accounts. Taxes on income and gains from investments held in IRAs, 401ks, etc. are deferred until the money is withdrawn. However, at that point income and gains are both generally taxed as ordinary income. Investments in Roth IRAs grow tax free.

Investor Expenses: Sales Commissions/ Loads

Another expense borne by many mutual fund investors is the sales load or commission. These one-time costs are sometimes incurred upfront at the time of purchase, sometimes at the time of sale. Many fund families offer multiple fund "classes" for each fund. In that case, the fund class determines the type and size of commission. Typically, fund class A is front loaded; commissions can range up to 5.75% or more. Note that in the case of a 5.75% load, since $100 only buys you $94.25 worth of fund assets, what they call a 5.75% load is actually a commission of ($5.75/ $94.25=) 6.1%.

If you are buying a mutual fund, you can minimize this cost by buying from a no-load or low-load fund family.

Investor Expenses: The Mutual Fund Expense Ratio

The expense ratio covers the cost of fund management, research & administrative staff, advertising, facilities, etc. It is the sum of these yearly operating expenses expressed as a percentage of the fund's investment assets. If a fund's investments grow by 10% every year, and the fund has an expense ratio of 1%, the fund's price, or net asset value, will increase (10% - 1%=) 9% per year.

While the expenses ratio is usually smaller than the sales commission, because these costs are incurred every year, they may have a larger negative impact on your returns than the more obvious commissions. For example, suppose a fund has class A shares with a 5.75% front load and class C shares with a 0% load. If the expense ratio for the class C shares is 0.75% more a year than class A shares (not unusual), then over holding periods of 10 or more years class A shares are likely to provide the superior return.

Index funds typically have the lowest expense ratios since they obviously require little or no research into the individual stocks being purchased. Their expense ratios can be 0.1% or even lower.

Investor Expenses: Transaction Costs

As you know, it costs money to buy and sell shares of stock. Whether you buy the shares directly or through a mutual fund, you will incur these costs. These costs are not included in the expense ratio, and mutual funds do not report these costs separately; they are simply added to the cost of shares purchased, or deducted from sales proceeds (thus, reducing returns). A fund's turnover rate can give you an indication of whether its brokerage fees are likely higher or lower than usual.

Because they have low turnover rates, index funds tend to have among the lowest transaction costs.

The Surprisingly Large Impact of Annual Expenses on Returns

Even ignoring taxes, many mutual fund investors average 2% per year, or more, in expenses. Just in case you think 1 or 2% doesn't make much difference, the chart at the top of this page (click to expand) should disabuse you of that notion. The chart shows the growth of $1,000 invested with no load at age 25 and held tax free, with dividends reinvested. The green line shows the results if the investment grows at 10% per year; the other two lines show the results with returns reduced 1-2% per year to represent the impact of expenses.

Just 2%/Year in Expenses Reduces This Retirement Portfolio by 50%!

Because of the magic of compounding, relatively small changes in annual returns can have a huge impact when compounded over many years. In this case, by age 90 a 1% expense ratio reduces what would have been a $490,000 portfolio to $271,000. A 2% expense ratio reduces the portfolio to $149,000 -- the ending portfolio is reduced by $340,000 and nearly 70%! Even if we only consider the impact to age 65, a 2% expense ratio reduces the ending portfolio by over 50%, from $45,300 to $21,700.

While 2% may not sound like much, in this case it would mean that fully (2%/10%=) 20% of the expected return would be lost to expenses each year. As a result, the ending portfolio would be reduced by over 50% over a 40-year time-span, and by nearly 70% over 65 years!

Conclusion

This is an overview of the primary expenses that impact investors' returns. They will have the largest impact for those investors who invest primarily in mutual funds. However, even if you buy individual stocks, taxes and transaction costs will lower your returns.

In a future post, we'll take a look at some other factors that conspire to lower the returns that real world investors receive when compared to the reported market returns.

The Surest Way to Increase Investment Returns? Reduce Expenses!: explains why small changes in yearly expenses have such a large impact.
Why Mutual Fund Owners Earn Lower Returns Than the Funds They Own (!): Investors' returns are not just lower than market returns, they're lower even than the funds' returns.
Expense Ratio, from the Morningstar Investment Glossary.
Mutual Fund Fees and Expenses, from Wikipedia.
The Magic of Compounding: Other examples of the impact of compound interest over long periods.
Stock Market Returns for Selected Time Periods: "theoretical returns" for the last 5, 10, 20 years.
For lists of other popular posts and an index of stock market posts, by subject area, see the sidebar to the left or the blog header at the top of the page. Copyright © 2011 Last modified: 2/23/2012