by Archie M. Richards, Jr., CFP^®
February 6, 2006

The stock market, as always, is outta control - gyrating unpredictably from one minute to the next. But there's a vital aspect of investing you can control: Choose investment vehicles with low costs.

Most mutual funds are actively managed. They try to select stocks (or bonds) that will outperform the averages. Analysts pour over financial statements, visit companies, talk with managers, and spend a lot of money doing it. The costs are deducted from the fund. It's your money they're spending.

In most industries, prices decline as the volume increases, with electronics the foremost example. Not so mutual funds. Since 1980, the market value of mutual funds grew nearly 70 times, from less than $100 million to $6.5 trillion. During the same period, the average annual costs almost doubled from 0.75 percent to 1.6 percent of assets invested.

(The reason mutual fund prices have risen despite higher volume is probably because, unlike electronics, mutual funds are heavily regulated. In the long run, the actual results of big government are opposite to the intended results.)

Here's another kind of mutual fund cost: Actively-managed funds are constantly jumping in and out of stocks, trying to take advantage of the latest dope before anyone else.

When they trade, mutual funds pay commissions and the difference between bid and asked prices, just as we all do. For example, let's say Dupont is selling at around $40. To buy it, you'd have to pay something like $40.02 a share. To sell it at that moment, you'd probably receive only $39.98. The difference, called the "spread," is retained by the market makers.

Spreads widen for institutions trading tens of thousands of share at a time. Mutual funds generally give up about 1 percent every time they trade a stock. And funds are trading more rapidly than they used to. Since 1980, the rate of turnover of mutual fund portfolios has risen from 20 percent to nearly 100 percent a year.

A third level of cost: With turnover so rapid, more and more proceeds are taxed as short-term capital gains, subject to high tax rates of up to 35 percent. Guess who pays those taxes - you do. If funds cut back on trading, most proceeds would be subject to long-term rates at a maximum of only 15 percent.

A fourth cost: If you buy a fund through a brokerage firm, the firm has numerous ways of getting paid: a deduction from your account up front, a deduction from your account when you redeem within a certain number of years, operating costs and marketing costs deducted from the fund as a whole, or a combination thereof.

Selling costs (not including transaction and tax costs) are spelled out in the firm's prospectus. Check under "Shareholder Fees" and "Annual Fund Operating Expenses."

The total costs of actively managed funds, including sales charges, operating expenses, and transaction costs (but not taxes) now amount to something like 3.3 percent a year.

Contrast this with Vanguard index funds, which are not actively managed. They just buy and hold the stocks included in the index they're tracking. With no sales charges, very low annual costs, and low turnover, the annual costs approximate 0.3 percent a year.

Let's say that two hypothetical funds start with $10,000 each. Both return 10 percent a year before costs.

Fund A's costs are 3.3 percent, resulting in a net annual return of 6.7 percent. In 30 years, Fund A would be worth $70,000.

Fund B's costs are 0.3 percent, resulting in a net annual return of 9.7 percent. In 30 years, Fund B would be worth $160,700.

With the lower-cost (and lower-trading) fund, the investor ends up with more than twice as much! Even though the investment results are the same, the managers, brokers, market makers, and salesmen of the more-expensive fund take more than half the money.

You can't control the market. Control what you can. Concentrate your money in mutual funds or exchange-traded funds whose costs are no more than 0.3 percent a year and whose rate of turnover is no greater than 15 percent a year. Low costs pay off far more than most people realize.