This post is part of a series where personal finance expert Dan Solin looks at money secrets that help the rich stay rich. See more.Most investors don't realize that the biggest factor in reducing their returns are the costs associated with their investments.
These costs include commissions, loads, taxes, advisory fees, market-makers, transfer agents and related costs. When you add them up, they can be very significant, reducing overall returns by as much as 40%!
Actively managed mutual funds (funds that try to outperform a given benchmark) have high turnovers of their portfolios. High turnover generates taxable transactions. The tax hit is carried by the investors in the fund, even when they don't sell their shares.
Here is one example:
The actively managed Fidelity Contrafund had a turnover of 60% in 2006. The passive Vanguard 500 Index Fund had a turnover of 7% during the same year.
When you deduct all of the costs and fees from the average equity fund earning a hypothetical 16.9% annualized return, the reduction in return is a whopping 5.7%. The average index fund would have a reduction of only 1.1%, primarily due to its low turnover.
On an initial investment of $10,000 for a fifteen year period, after deducting all of these expenses, the average actively managed fund would grow to $49,000. The average index fund would have grown to $90,000 over the same time period.
When you read about the stellar returns of actively managed funds, remember that they are reporting only pre-tax returns. The after-tax returns of these funds are typically reduced by 40% or more.
Rich people compare after-tax returns to after-tax returns when deciding how to invest. When they do so, they find that index funds outperform 95%+ of actively managed funds.
Rich people understand that it's not what you make, it's what you keep that counts.
Dan Solin is the author of The Smartest Investment Book You'll Ever Read (Perigee Books, 2006) and The Smartest 401(k) Book You'll Ever Read (Perigee Books, 2008).
Dr. Doom Nouriel Roubini believes the bubble is about to burst
Cramer on BloggingStocks: Investors are rethinking their snap judgments 
Lions Gate Entertainment: Still waiting for cash flow
Reader Comments (Page 1 of 1)
12-06-2008 @ 11:49PM
Ruchika said...
Surprisingly,what lot of people thought was a safe investment - real estate, got them to trouble. Everyone thought that this was something for the keep.. for this and next generation, and now are struggling with lower valuations, default payments.