Sunday, January 28, 2007

Why Controlling Fees and Expenses Matters (Part 4 of a five-part series)

Figure Caption: Shopping for groceries is an everyday example of how to exercise control over small factors . . . which ultimately add up to a lot.

Running an efficient portfolio is the easiest way to "stack the cards" in your favor to achieve long-term investing success. Let's begin by way of analogy--with a trip to the supermarket.

How Do You Shop for Your Groceries?

You might have heard that Ben Graham recommended investors buy stocks like they buy their groceries (and not as if they are splurging on perfume). Well, over the year-end holidays my wife and I happened to receive as a gift a 1000-page coupon book for 2007. Though I don't much enjoy clipping coupons, I was curious enough to find out if the book really is worth its $40 retail value and began to page through it. One of the most useful discounts in the book is a set of four "$5 off" Safeway (SWY) coupons, one for each season of the year, valid when purchasing $50 or more of groceries. Because my wife (who does most of our grocery shopping) was tied up last week, and since I wanted to make sure that we use the winter coupon before it expires later this month, I decided to make a run to Safeway myself.

With the weekly Safeway ad in hand, I strolled into our local store, grabbed a cart and started down the aisle. Since oranges were on sale for just $0.33 a pound (an amazingly low price, particularly in light of the recent news of an estimated $1 billion of frost damage to crops in California), I loaded up on 20 pounds' worth. Noticing broccoli and cauliflower at $1 a pound (a good price for the winter season), I bagged a few pounds of each. Continuing on to the meat section, I found the chicken breasts advertised at $0.99 a pound (regularly $1.99 a pound) and the London broil steaks at $1.99 a pound (normally $4.79 a pound) and selected a couple of packages of each. In the bakery section, New York-style bagels were on special (three for $1); so I picked up a dozen. The French bread, hot and right out of the oven, was on sale for $0.99 a loaf (regularly $1.39) and smelled too good to pass up; so I tossed a couple of loaves into my cart. Then came the laundry detergent, toilet paper, toothpaste, tortillas, milk, cookies and ice cream--all on sale--to top off my shopping cart.

When the cashier rang up my total, it initially came to $115. Then, miraculously (listen up--this the important part), after I slid my Safeway club card through the reader and handed the "$5 off" coupon to the cashier, my total dropped precipitously to, not $100, nor $90, nor even $80, but all the way down to . . . $55! Amazing! A 52% discount, just from selecting sale items, showing my Safeway card and using a discount coupon. And, guess what? I even got a bonus: because I spent more than $50 in a single purchase, the next time my wife or I fill up with gas at the Safeway pump, we get 10 cents off per gallon, which will save us another buck or two.

That's how I shop for my groceries--paying attention to what's on sale and taking advantage of discounts that come my way. Really, it takes very little extra time and effort to realize significant savings in a most predictable way.

The Control Factor

Moreso than the absolute dollar amount of savings on groceries, the important point here is what I like to call the "control factor," i.e., taking advantage of elements that are within your sphere of control. In the context of investing and maximizing net worth: when you have the opportunity to improve your returns by exercising a little more care in how you go about managing your personal finances, you should!

We can also see this principle at work in Ben Franklin's advice, "A penny saved is a penny earned," in Warren Buffett's willingness to stoop down low to pick up a penny in the elevator even though he's already a multi-billionaire, and in the secret to riches as reported in Thomas Stanley and William Danko's The Millionaire Next Door. Essentially, controlling the parts of your personal income statement that you can--whether part of earnings, savings or expenses--is vitally important to wealth-building.

The nature of markets is that so many factors are beyond our control. We do not know with much certainty if the particular stocks we own will rise or fall tomorrow, whether interest rates will head up or down next month, which way oil and gold prices are headed, or if the dollar will strengthen or weaken next year. All of this uncertainty creates the "volatility" that investors worry about but shouldn't. My point is that, instead of spending the time worrying about the big "macro" factors you cannot control, you should focus on the more manageable, comparatively small items that you can control. Learning to take advantage of the opportunities offered by what is within your grasp is often what makes the difference between winning and losing in investing.

Low-Cost Investing

Let's now consider an example from long-term investing. You've probably heard of John Bogle, the Vanguard founder, who is adamant about the advantages of index funds over actively managed mutual funds. In a recent speech, Bogle provided results of a study indicating how actively managed mutual funds with higher expenses and turnover have grossly underperformed those funds with lower expenses over the decade 1995-2005. As shown in the table below, the performance differential between the low-cost and high-cost quartiles over this ten-year period is a striking 75 percentage points (207% for the low-cost quartile vs. 118% for the high-cost quartile). Clearly, anyone would be happier seeing their $1000 grow to $3070, instead of the lesser figure of $2180, over a ten-year period. This is the low-cost advantage.

Bogle concludes that "Yes, costs matter." He also goes further to advise: "So do your best to minimize your investment expenses and your own emotions, rely on your own common sense, be very careful, and then stay the course." I agree wholeheartedly.

Efficient Investing Habits

In the broader context of personal portfolio management, here's what I recommend:

  • Self-Reliance: Cultivate an open-minded, do-it-yourself attitude. I have found that keeping my investment portfolio simple allows me by and large to avoid calling on expensive experts (accountants, lawyers, financial advisors). If and when you do hire professionals, make sure that they are delivering value to you that more than offsets what they are charging you for their services.

  • Minimize Fees and Expenses: If you enjoy the challenge (like I do) of picking your own stocks and properties to invest in, by all means go ahead and do so!--since this way you keep your out-of-pocket portfolio management expenses to a bare minimum. If you are not comfortable or just do not want to spend the time picking your own stocks, do the next best thing--buy index funds to keep fees and expenses low. Avoid actively managed mutual funds, unless you are convinced that the fund manager has a superb track record that is likely to continue. Note that even the fund managers with the best performance records, such as Bill Miller of Legg Mason's Value Trust whose 15-year streak of beating the S&P 500 ended last year, can and do have bad years.

  • Low Turnover and Taxes: Keep portfolio turnover as low as possible. I like to target 10% turnover per year, consistent with a 10-year horizon. Before buying any stock or real estate property, make sure that it is an investment you can expect to hold for the next decade. Low turnover saves on commisions and bid-offer costs that degrade returns. It also means lower taxes from tax-deferred compounding of embedded gains, since capital gains taxes are due only at time of sale.

  • Don't Worry About What You Can't Control: While it may seem counter-intuitive, you should care more about the $100 you can easily save, than the $10,000 swings in the value of your portfolio that you have no control over. Over the long haul, the small $1, $10 and $100 savings have a way of adding up to increase your odds of outperforming the market, while the large $1,000 and $10,000 drops in portfolio value due to market volatility tend to get more than offset by positive moves (recall that equity markets tend to rise over time).

To sum up, you can and should take advantage of the controllable, easy-to-find discounts and "freebies" that enhance your chances of being successful long-term as an investor. Work on what you can control--let the secular upward drift of the market take care of the rest.

Next week: Bringing it all together


Blogger Mikez said...

Does it always apply? I mean the low cost investing against the high cost investing idea? I would think that investing in highly-managed high cost mutual funds would outperform a low cost mutual fund, but their are times when as stated low cost investments have bigger returns over high cost ones. The investment returns depends much on not just on the market but most of all on how it is managed, how diversified the investments where on the funds and which of those investments performed well or not.

10:51 AM, April 30, 2007  
Anonymous said...

Very effective material, thanks so much for this post.

10:05 AM, October 20, 2011  

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