It's Not How Much You Pay in Costs, It's the Total Return That Matters

I wish I had a dime for every time I've heard this statement from Wall Street. How can anyone argue with it? It's an absolute truism, yet it's completely irrational. Let's walk through the argument.

This is how it goes:

If you needed heart surgery, you wouldn't go to the cheapest heart surgeon, would you? So why would you use the least expensive investment vehicles?
Aside from being an absurd "apples and oranges" comparison, this argument has a fatal flaw. My surgeon wouldn't need to make someone else sick in order to make me better. Investing, on the other hand, is a zero sum game. Since the stock market can only return whatever it decides to return, and since 90% of the market is professionally managed or advised, one professional must outperform at the cost of other professionals if he or she is to add value. After costs, the vast majority will fail in the long-run.

Why this statement is irrational
Clearly, total return is more important than costs. But the higher the costs, the more the professional must outperform other professionals just to break even. The data supports the logic that higher fee investments tend to have lower returns. An example can be seen here for mutual funds where higher costs lead to lower performance.

It is the data that shines a light on the irrationality of the "returns over costs" statement. Rather like saying "it's not whether you smoke, it's how long you live that matters." Kind of an illogical statement since smoking tends to lower your life expectancy. In investing, costs tend to lower your returns.

A more rational statement
The next time you hear the statement that returns matters more than costs, I recommend you agree with them. Then say, "The best predictor of returns for each asset class has been shown to be costs." The best way to get higher returns is to lower your costs.

The next time you hear the statement "don't worry about costs, worry about total returns," be careful that you may be about to fund someone else's retirement plan.

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