Thursday, September 17, 2009

The importance of investment costs

The simplest portfolio choices with the lowest costs can equal better long term gains than a high cost investment. Do you own any mutual funds? Do you know what the expense ratio is for your fund(s)? If the answer is no, read the most recent prospectus (the pamphlet with all the financial jargon in it you get annually). You may be surprised to know there are most likely lower cost funds that have matched or beaten your mutual fund(s).

Over time, an investment that had an expense ratio, or cost, of 0.2% annually vs an investment with an expense ratio of 1% will illustrate the importance of looking at costs. A higher expense ratio will eat into your compound interest year after year.

A $20000 dollar investment, at a rate of return of 6% and expense (or cost) of 0.2%, over a period of 35 years will yield around $144,000. This is a one time investment, with no regular contributions, which even with small additions would result in a much higher amount.

The same investment, with the same numbers except with a higher expense ratio of 1% would yield around $108,015.

With this example you can see that a higher cost investment will yield a much lower result. In reality, it is a hidden but direct reduction to your rate of return. A small percentage change in expenses adds up to 25% less money at the end of your savings window in this example. Pay attention to your expense ratios!

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