Last Updated Nov 12, 2010 11:17 PM EST
Yet despite the incontrovertible nature of this fact, mutual fund investors continue to make choices that are completely illogical -- even those investors whom you would think are smart enough to realize that paying less for an investment is better than paying more.
Exhibit A of investors' inability to grasp this fundamental law of investing was famously illustrated in a study that was recently updated and published in the April 2010 issue of The Review of Financial Studies.
In the study, authors James Choi, David Laibson, and Brigitte Madrian asked Wharton MBA students, Harvard underclassmen, and Harvard staff members to make a hypothetical investment of $10,000 in one or more of four different S&P 500 index funds.
S&P 500 index funds are clearly commodities. They all invest in the same stocks, with the same weights, with the same goal of simply matching the performance of the index itself. They differ only in the amount of expenses they charge.
And just as it makes little sense to pay more than necessary for a bar of gold, an ounce of copper, or a pound of sugar, so it makes little sense to pay more than necessary for an S&P 500 index fund.
Given that, the study's authors were interested in measuring the ability of their subjects to make smart investment decisions.
The participants in the study were divided into three groups. Group A was given each fund's prospectus and a "fee sheet," which highlighted the funds' fees that were described in the prospectus. Group B was given a prospectus and a "returns sheet," which showed the average annual return each fund had earned since its inception. (Because each fund in the study had a different inception date, the returns listed differed; a fact that obviously had nothing to do with the funds' expected relative performance in the future.) The final group was given only each fund's prospectus. (The Harvard staff members, who weren't part of the original version of this study, included a fourth group, which received a list of "frequently asked questions" that explained what index funds are.)
Finally, to provide the participants an economic incentive to choose wisely, they were told that one participant selected at random would receive any profits their selection earned over one year.
Given the obvious intelligence of the study's participants, and the fact that fees are the sole differentiator of index fund performance, you would expect that the vast majority of the study's participants would choose to invest their entire portfolio in the lowest-cost index fund available.
You would be wrong.
The authors found that the participants "overwhelmingly fail[ed] to minimize fees."
The average Harvard staff member selected a portfolio that cost them 2.01 percent more than was necessary. The average Wharton MBA student paid 1.12 percent more than was necessary, and the average Harvard student paid 1.22 percent more. Over a decade or more, those fees would erode an enormous portion of the return that was otherwise available.
The participants in the study also demonstrated a remarkable disconnect between what they said was important and the decisions they made. Both the Harvard students and Wharton MBAs who received the fees sheet indicated that expenses were the most important criteria they used in making their selections, yet they allocated only 30 percent and 43 percent, respectively, to the cheapest fund available.
But even more dispiriting is the fact that participants in every group -- and regardless of the educational material they received -- indicated that past performance was one of the two most important criteria they used in making their selection. Clearly, because the funds were all 500 Index funds, past returns were particularly meaningless and implied nothing about the ability of one fund to outperform the others going forward.
Finally, in a survey conducted after the investment choices were made, the authors found that the participants who paid the highest fees indicated that they "doubted that they were making the best portfolio allocation."
In other words, they suspected they were wrong, but this group of otherwise intelligent and accomplished individuals was incapable of determining precisely why, despite given an economic incentive to choose wisely.
As I noted in an earlier post, this sort of financial illiteracy is, unfortunately, rampant. And even worse, rather than helping combat it, the vast majority of participants in the financial services industry benefits from it in the form of enormous profits on high priced products and services.
Rather than cursing the darkness that this scenario seems to present, light a candle, and endeavor to educate yourself on how to separate what's real and enduring (such as costs) from what's fleeting (such as star ratings and past performance) in the investment world.
And if you feel incapable of making such a determination, or simply want a second opinion on your decisions, by all means seek assistance. But in doing so, make sure that you're enlisting the help of a disinterested third party -- paid only by you -- who has a fiduciary duty to act solely in your best interests.
Do so, and you'll be well on your way to investment success -- and a wiser investor than the typical Wharton MBA, to boot.
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