When it comes to wealth optimization one problem which comes up is finding a foolproof strategy for increasing your bottom line. Strategies like investing in stocks, radical budgeting and savings, or starting a small business all work for some people, but not for others. This aside, one thing which is likely to act in your favor is reducing your investment expenses. Investing costs, whether they are transaction costs for buying or selling securities or management fees for holding mutual funds, should be minimized.
Why? There are at least two reasons.
Investing Fees Reduce Returns
Every dollar paid for management fees or trading commissions is simply a dollar less you have invested. This holds true for real estate transactions, loan brokerage fees, stock commissions and mutual fund management fees.
Lets take an example from the stock markets. There is lots of good stock market data, so this example holds some water. Assume you start by investing $100,000 in two different funds. The first fund has an expense ratio of 0.25%. The second fund has an expense ratio of 0.90% (which is the approximate asset-weighted average expense ratio for U.S. stock funds as of December 31, 2012). The impact of expenses over a 30-year horizon with 6% annual compounding is huge. At the of 30 years the low cost fund gives you $532,899 whereas the high cost fund yields only $438,976. The difference here is almost $100,000 (coincidentally, the portfolio’s starting value) between the low-cost and high-cost funds.
Costs Are Controllable
The key point is that—unlike a lot of things—costs are largely controllable. The stock or bond markets may decide to hiccup and you could lose a substantial portion of your investment. Acts of god, like hurricanes, earthquakes or incidents of civil disturbance are also beyond your control. Most assets are also subject to some sort of political risk, typically politicians seeking to impose regulation or increase taxes on markets which your investments are part of. The point here is that you can’t easily do much about these sources of risk to your portfolio. That said, you can control costs – that is by choosing mutual funds which have lower expense ratios or by selecting brokerage houses which have low or no transaction fees at all.
So, just to recap: a good way to optimize your finances is to control costs. Cost control works for everyone. Costs eat into your returns and reducing costs puts you in the drivers seat, which is great because anytime there is money on the table you’ve got enough risk to worry about.
P.S. Hat Tip to the Vanguard Group for the example figures (clicky).