A Free Lunch: Higher Returns with Lower Risk
It's far from a newsflash to note that the expenses you pay for your mutual funds can have an enormous impact on the returns you earn. Investors who spend even a modest amount of effort learning the basics of investing should know that even seemingly tiny differences in mutual fund expense ratios can lead to enormous differences in wealth over time.
But in seeking to minimize the expenses you pay, you can do more than maximize your portfolio's long-term growth. Doing so can also allow you to take on less risk in pursuit of your goals.
How? Read on.
The best control over our portfolio's risk is our asset allocation -- most simply, our mix of stocks and bonds. We own stocks -- and endure their volatility -- because historically they have provided long-term returns that outpace bonds (which is known as the "equity premium"). We own bonds to shield us a bit from the market's inevitable declines along the way.
But no one needs a reminder of the fact that we can go through long stretches in which that equity premium vanishes, and stock returns lag bond returns, as in the current decade. To combat the uncertainty of future market returns, we ideally settle upon an asset allocation that balances our need for long-term growth with our desire for stability. And the asset allocation we choose will have an enormous impact on the long-term returns we earn.
But a strategy of minimizing your investment expenses can provide you with a bit of a free lunch relative to your peers, allowing you to earn better returns with lower risk.
To illustrate, consider that over the past 20 years, the total stock market has provided an annual return of 8.1 percent, and the total bond market has earned 7.1 percent. Thus, an investor with a 60/40 stock/bond portfolio, paying the fund industry's average expense ratio for their stock funds (1.36 percent) and their bond funds (1.0 percent) would have earned a net return of 6.5 percent.
If instead their expenses were a rock-bottom 0.1 percent for their stock fund and 0.2 percent for their bond fund, their annual return would have been 7.6 percent.
No doubt about it. Expenses matter.
But here's the twist. Suppose our low cost investor chose a more conservative portfolio of 40 percent stocks and 60 percent bonds. Their annual return would have been 7.3 percent -- some 12 percent higher than the return earned by their more-aggressively-invested, average-expense-paying peers.
To give you an idea of the sort of peace of mind that such conservatism would have provided in the recent bear market, consider how the two portfolios would have performed in 2008. A 60/40 stock/bond mix would have lost 20 percent, while the 40/60 mix would have lost 12 percent. That eight percent difference would have provided quite a bit of peace of mind as investors opened their year-end statements, and might have prevented a few from bailing out of the stock market entirely, and thus missing this year's partial recovery.
The equity premium was so narrow over the past 20 years that an investor in an average cost portfolio invested entirely in stocks would have lagged the returns earned in a low-cost portfolio invested entirely in bonds (6.7 percent versus 6.9 percent, respectively). Still think that costs don't matter?
Of course, it's impossible to know what sort of equity premium (if any) investors will earn in the next two decades, even as it would be unrealistic to expect that the narrow spread of the past 20 years will continue. But low-cost investors can still reap outsized rewards relative to their average-expense-paying peers.
History tells us that stock returns have exceeded bond returns by about three percent annually (reflecting stock returns of eight percent and bond returns of five percent). Using that as a reasonable guide, then, a low-cost investor with a 40/60 asset mix would earn six percent annually, while an average cost investor would earn 5.6 percent with a more aggressive 60/40 mix. The low-cost investor earns higher returns, with lower risk.
Given that we've just endured one of the stock market's worst decades in history, many investors are rethinking their ability to handle the market's ups and downs. After learning first-hand how fleeting that precious equity premium can be, it seems absurd to squander large chunks of it in the form of even average mutual fund expenses.
But by trimming expenses to the absolute minimum, it is possible for investors to lower their overall stock market risk yet still outperform their more aggressive, average cost paying peers. And that's about as close to a free lunch as you're likely to ever find in the markets.