After reading a post on Bucking the Trend’s (now defunct) site entitled, How Vanguard Will Save Me $2,700 and the outstanding must-read Stock Series by JL Collins, I realized I needed to learn more about low-cost index fund investing.
I picked up The Little Book of Common Sense Investing by Vanguard founder John Bogle and it turned my financial world upside down in the most positive way possible. It was so elegant and compelling in its simplicity that I was instantly hooked. I consider this book an absolute must-read, so I hope you pick it up (at the library of course).
The Basics
I’d sum up his entire theory this way: There is essentially not one person on earth who can beat the stock market over a long-term period, and therefore the best anyone can hope for is to match the returns of the stock market. Any fees you pay to a mutual fund, financial advisor, commission, trading fees, etc. just pull down your return as compared with the overall market.
When you hear that a mutual fund has a 0.75% expense ratio and maybe your financial advisor charges you 1.25% of your ‘assets under management,’ it just doesn’t sound like a lot. As we’ve pointed out before in our The Miracle of Compound Interest article, it is astounding how small differences in returns can make a significant impact on your account balances when compounded over a long period of time.
An Example
To illustrate, I made a wild example in the below chart showing what a $1,000,000 investment would be worth after 100 years compounded at a 9% gross annual rate. I then reduced that 9% return in three ways: 1) by the 0.05% expense ratio on Vanguard’s VTSAX Fund (Total Stock Market Index Fund) for an 8.95% net annual return 2) by the typical 1% mutual fund expense ratio for an 8% net annual return 3) by the 1% mutual fund fee plus 1% for a financial advisor’s fee for a 7% net annual return:
As you can see above, these fees make an unbelievable difference when compounded over this time period! The $1.0 million investment would be worth $5.53 billion at the 9% gross return (!), but only $867 million at 7%. You would literally lose $4.66 billion just by using an investment advisor who had you invested in a 1% expense ratio mutual fund. You’d lose $3.33 billion if you were smart enough to invest on your own, but for whatever reason invested in a mutual fund with a 1% expense ratio.
Or, you could buy the VTSAX index fund and own your piece of the entire US Stock Market and only pay 0.05% for the right to do so. You’d still lose $248 million to fees, but since this is essentially the lowest expense ratio available to common investors, you can’t do any better than that.
A Slightly More Realistic Example
Let’s look at someone who has $100,000 saved up and continues to invest $1,000 per month for 40 years:
(NOTE: This article was created in 2013 when 1) the expense ratio on VTSAX was 0.05%. It is actually lower now! 2) I assumed a 9% gross market return. Today I assume 8%, but the math still holds below to illustrate this point.)
With the advisor and 1% fund fee, they’d lose roughly half of their potential investment balance; with just the 1% fee they’d lose more than 25% of their potential balance, but with the Vanguard index fund they’d only lose 1.5% total over the 40-year period.
If you believe, like John Bogle and Warren Buffett do, that owning low-cost mutual funds is the best possible option for everyday investors, then it’s hard to go wrong with a fund like VTSAX.
2024 update: I prefer the Vanguard ETF version ‘VTI’ today because you can buy it without commissions or fees at places like Fidelity, Schwab and of course you wouldn’t pay fees for either VTSAX or VTI at Vanguard itself.
But realistically, there are many options for ‘Total Stock Market’ and ‘S&P 500’ mutual funds and ETFs outside of Vanguard that are fantastic.
I recommend the ETF versions because often people make the mistake of buying another firm’s mutual funds at a brokerage (for instance, they have a Fidelity brokerage account and try to buy VTSAX there) and get hit with hefty fees (think $75 each time!) that make no sense.
There’s nothing inherently special about VTSAX, it is only a single example of a ‘total stock market’ mutual fund, but it is not worth paying fees just to have VTSAX because you heard someone mention it in the FI world somewhere!
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Hi Brad – good post. The impact of fees really opened my eyes when I went through a similar exercise. Expense ratios of 1.0 or 0.75 never really sounded like much until I projected out the bite they take out over a longer period of time, especially as ones investment egg grows. In the beginning, it was basically peanuts. But as you show, over decades it can mean the difference between financial independence now versus several years from now.
Thanks Buck, I’m glad you enjoyed it! Thanks for helping me on my way towards using Vanguard — I’m a fan of theirs for life now. It’s remarkable how these small differences can add up and really rob you of the full value of your return.
Until recently, I never gave much thought to fees. Then, I discovered the Fee Analyzer feature on Personal Capital which told me that I’d lose $500,000 to fees over the course of my life. Holy CRAP! I had no idea.
Thanks for the John Bogle book recommendation as well. I knew about Vanguard, but not about Bogle. Time to hit up the library.
That’s a great feature on the Personal Capital site and certainly very eye-opening! It’s astounding how much expense ratios and investment advisory fees can just destroy your return. There’s no way those advisors or those funds can beat the market over 30-50 year, so you’re just paying them to take your money. It’s an insane system…
You will love the Bogle book, I guarantee it…
Great post Brad. Costs do matter and impact the return on your investment. I also enjoyed the book The Boglehead’s Guide to Investing…written by John Bogle’s disciples. The boglehead forum and wiki page is another great resource. Most of my funds are in Vanguard funds. There are plenty of funds that have lower minimums like the Target Retirement Funds which only has a $1000 minimum.
I’m glad you enjoyed the post Andrew! I’ve been meaning to pick up The Boglehead’s Guide — thanks for the reminder and great point about the Target Retirement Funds. I got mentally locked into the Total US Stock Market index fund since that’s the one that appeals to me the most, but there are plenty of other great Vanguard funds available.
I recently picked up his book: Enough. It’s quite good.
Good overview on why fees are so important. As a side note, did you know that his son runs an actively managed set of funds? His top fund charges 1.35% fees but is reported to have outperformed its benchmark by 4-5% since inception…
Glad to hear you enjoyed it; I really thought it was an entertaining and educational read. I actually just learned about that with his son, as it was in the Wall Street Journal this past week. I thought that was fascinating and I can only imagine how interesting their family discussions are! The son only has ~$1 billion under management, so I imagine that will come back to earth someday when they get larger.
Hi Brad…
Excellent post and I especially enjoyed your technique of using large numbers and long time periods to illustrate the profound cost over time of ERs.
This can also be used to illustrate the dangers of pursuing non-index strategies.
I just finished reading a post on another site about why the writer doesn’t benchmark his touted strategy against the S&P 500. Seems it doesn’t matter as he is only interested in living off his dividends.
But if he falls even one percentage point under that benchmark, and as a stock picker his short-fall is most like to be far greater, the loss over time will be every bit as stunning as paying the higher fees.
Oh, and as it happens, I also just finished the Bogle book you recommended. Easy and fast read and well worth any serious investor’s time.
And thanks for the link. Much appreciated and I am honored you would mention me in the same breathe as three other financial bloggers who are in a small group I most respect.
Jim,
Thank you very much for stopping by and commenting on the article — I sincerely appreciate it. Your Stock Series legitimately changed my life, so it means a lot to me that you enjoyed this post in particular!
After reading your series and the Bogle book, I can’t come up with a reason not to pursue a nearly solely index-fund strategy. It is so elegant in its simplicity and it makes intuitive sense to me, and you can outperform nearly everyone else with zero work and nearly zero fees. That’s incredible!
Beautifully said in that second paragraph, Brad. It is now Addendum III here: http://jlcollinsnh.com/2013/02/05/stocks-part-xv-index-funds-are-really-just-for-lazy-people-right/
With a link to this post.
Jim, What was the post about not using a benchmark? Thanks
Hi Mark…
Sorry for the delay in responding but we spent the holidays in Guatemala and since I travel sin-computor and hate my little phone, I am woefully behind in my correspondence.
Since I like the guy who posted that, and since I think it is an embarrassment to him (although he’d disagree), I would prefer not to say.
Sorry for the non-answer, but I didn’t want you to think I was ignoring you.
Jim,
No problem about the response time. I follow your blog and completely understand. I figured I would ask you because I remember reading that post, but forgot which of the many FI bloggers posted it. I was hoping to use it to help explain some stuff to my fiancee! I am not sure how to email you directly to ask, so if you are willing to tell me privately over email, please let me know. Thanks. Hope you enjoyed your Holidays!
Mark
Sure, happy to tell you privately.
Shoot me an email or post a comment on my blog that will allow me to capture yours.
We had a wonderful holiday and hope you and the rest of the RichmondS community did as well!
Hey Brad,
Great article. Any reason why you don’t try using something like Wealthfront or Betterment?
I’ve been on a bit of a journey these days looking to find where I can park the $51k ($52k next year, $53k the year after that etc) via my SEP IRA through my business. I’m coming from a previous bad experience of paying a pretty sizable front load fee on my investments with an American Funds advisor.
Chris
Hi Chris,
Glad you liked the article so much — I appreciate the kind words!
Honestly, at this point I am a true believer as far as the power of low-cost index funds go (specifically Vanguard Total Stock Market Index Fund), and I don’t need to pay Betterment or anyone even a small percentage of my assets to manage something that simply doesn’t need managing.
I was enthused to see that Warren Buffett recently released in his annual shareholder letter that this is his strategy for his own will: “My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.)”