How to increase investment returns -- Keep an Eye on Costs

Many investors' downfall is their focus on predicting asset prices, something they can't control. It doesn't help that gurus on financial channels and analysts at prestigious investment firms put out target prices for stocks and other assets daily. If you're caught up in the unending barrage of predictions and calls to buy, sell, or hold, consider Yogi Berra's great insight: "It's tough to make predictions, especially about the future."

Rather than trying and failing to predict the future, focus on what you can control.

When it comes to boosting your investment returns, besides asset allocation and not fiddling with it once it is set, investing costs are the most important thing within your control. The lower your investment costs, the higher your returns. This is so obvious and self-evident that it seems hardly worth mentioning, and yet most investors, professionals included, underperform the market and pay more out of pocket to do it.

There are several types of investment costs and simple strategies to reduce them.

Holding Costs

If mutual funds and ETFs are your main investment vehicles, one of the biggest factors that you can control is the cost of holding the fund. This is typically known as the net expense ratio of the fund, which is the percentage of your investment that the fund charges you for investing in it. This fee is used to pay its overhead costs and (except for Vanguard funds, which are owned by their shareholders) generate a profit for its corporate issuer.

For example, a fund that charges a 2% net expense ratio will take two cents from every dollar you have invested in it each year. Compare that with a fund that charges a 0.1% fee. What might seem like a small percentage difference can have a huge impact on your returns.

Suppose you invest $10,000, hold the investment for 35 years, and the underlying asset (e.g., US stocks) goes up 10% per year. If you buy a fund that invests in the underlying asset and charges a net expense ratio of 2%, at the end of the 35 years your holding will be worth $147,853. However, if you buy a fund that invests in the same underlying asset but charges a fee of 0.1%, at the end of the 35 years your holding will be worth $272,219, or 84% more. With the 2% fee, you would pay $133,171 to invest in the fund. With a 0.1% fee, you would pay $8,805.

Looking at this huge difference, made by  an extra 1.9% per year over time, one might wonder why anyone would choose the 2% fee fund over the 0.1% fee fund. Yet a lot of people do. Sometimes we have no choice, as in a 401k plan. Other times it's unscrupulous brokers and advisors that peddle the expensive funds to unwitting clients. The rest is our ignorance coupled with the expensive fund's advertising, which is paid for with the high fees.

Before fees, the vast majority of funds return very close to their benchmark in each asset class. Funds that charge more than their rivals promise better overall returns, but this almost never happens over the long term, in large part because of the fees. Or rather, the investor gets the shaft and the fund firm reaps the rewards. By buying an expensive fund, you're basically saying to the fund manager, "I'll take all the risk and pay you a lot of money whether you do well or poorly."

So how do you minimize your holding costs and therefore boost your returns? Choose the lowest expense ratio fund in the asset category in which you are seeking to invest. If you are in doubt, go with a Vanguard index fund. They are among the cheapest investment vehicles around, and the company is customer centric because it is owned by its customers. If you don't like Vanguard or their mutual fund investment minimums are too high for you, take a look at getting a Fidelity account. Fidelity now offers zero expense ratio funds. (These don't make money for Fidelity, but the firm is hoping you'll buy one of their other products once you are its customer. The zero fee funds also increase Fidelity's assets under management, which they can leverage to increase their profits in other areas.)

Besides zero fee funds, another way to get rid of fees is to invest directly in the fund's underlying assets. This works best with stocks. For example, instead of paying the 0.09% for SPY or 0.03% for VOO or IVV, the ETFs that track the S&P 500 index, you can buy all 505 of the index's holdings directly. If you do it at a broker with no commission fees, you'll pay no fees at all.

(If you do it at a broker that does charge fees, you should only proceed if you have enough capital, that is, if the trading fees are insignificant when compared to your investment's value. Five or more years ago I'd say this is the way to go, as you'd only pay the fees once--provided you didn't sell--and your investment would grow fee free thereafter. Index funds have gotten so cheap nowadays, however, that it's much easier to buy the fund than the individual holdings.)

The Three Types of Trading Costs and How to Minimize Them to Boost Returns

Similarly to fund fees, trading fees also curb investment returns. They come in three different flavors: traditional broker commissions, taxes, and portfolio turnover, which is a combination of the first two.

Broker Commissions

ETFs and Individual Stocks

The first and most obvious trading fee is the commission you pay your broker when you buy or sell a stock, bond, mutual fund, ETF, or other investment instrument. Commissions have gone down over the decades but many investors still pay from five to ten dollars a trade.

There are two simple ways to lower your commission fees: trade less often and/or find a broker that charges lower commissions. There is a growing batch of brokers that charge no commissions at all. These include Firstrade (traditional discount broker that recently adopted a no commission policy), Robinhood, M1 Finance, and Webull. (The latter three are geared more toward millennials. If that's you, check them out. As of August 2019, both Robinhood and Webull offer free stocks for signing up. Older investors, however, might find these less pleasant to use. I'm right at the edge of millennialdom, in my late thirties, and have a lot of trouble with the apps' interfaces. From my experience I'd say Robinhood is the best in terms of trading while M1 is the best in terms of long term investing per a specific plan or asset allocation.) Most other brokers offer ETFs commission free as well as no transaction fee mutual funds. One thing to watch out for with no commission ETFs is that the broker might cut its relationship with the ETF family, so you would incur fess if you sell the fund.

Trading less often to save on commissions may seem obvious, but I've known several people that just didn't get it. They would pay $7 a trade and buy $25 worth of a stock or ETF each time. If this reminds you of yourself, please for the love of everything holy stop doing that! You're better off not buying anything. At $7 a trade, it's $14 for the round trip (buy and sell), so you're out 56% at the start when you invest $25. That $25 investment needs to increase by 79% for you just to break even!

The better strategy, apart from switching to a commission free broker, is to save that $25 until it builds up to at least $700, where your round trip fee would be 2% of your investment. In other words, the stock or ETF would only have to go up 2% for you to break even on the trade.

Mutual Funds

Many mutual funds have a trading fee called a load, which is charged either when you buy the fund (frontend) or when you sell it (backend). Loads are usually a percentage of the dollar amount you are investing into or selling from the fund. For example, if you invest $10,000 into a fund that charges a frontend load of 5.75%, you're going to pay $575 for the privilege and actually have only $9,425 of your money invested in the fund. You'll then pay the fund's net expense ratio on top of that. No thank you!

Same story with a backend load fund, except you'll end up paying more if your investment grows. Suppose you buy a fund with a 5.75% backend load. If your $10,000 grows to $15,000 and you sell it, you will end up paying a fee of $862.50 and keeping $14,137.50.

Whether you take the load hit when you buy or when you sell, you are doing substantially worse than investing in a fund with similar holdings and no loads. If you're investing in mutual funds, look for no transaction fee, no load funds with low expense ratios (be aware that there are funds out there that charge nothing (Fidelity zero funds) or hundredths of a percent, and use these as your baseline).

Bonds

Trading commissions on individual bonds are hidden by most brokers that offer bond purchases. Bonds are usually offered at a net yield, meaning that the broker takes its cut behind the scenes and the offer price you are presented already includes the fee.

A good way to lower such fees and increase your diversification is to buy a no transaction fee, low expense, no load bond mutual fund or a low expense ETF that your broker provides commission free. As bulk purchasers of bonds, funds are able to get much better prices than the fund fee you pay in exchange. On top of that, you get bonds across a broad spectrum of issuers, which helps offset the risk of any one bond issuer going bust.

The exception to this is Treasury bonds that you buy at auction. Most of the major brokers offer these with no commission fees, but note that there may be minimum order quantities. Treasury Direct is a good place to buy Treasury bonds that you are planning to hold to maturity.

Taxes

The second type of trading fee is taxes. You might not think of it as a trading fee, but if you sell an investment at a profit, the government charges you a backend load. The government also charges taxes on any income that your investments produce.

If you own an investment less than one year before you sell it, your profit is a short term capital gain. Short term capital gains are taxed based on your income tax bracket. In 2019 this can be as high as 37%.

Say you're in the 22% tax bracket and you make a $5,000 profit on a short term trade. The government will take $1,100 for the privilege, leaving you with an actual return of $3,900. Ouch.

By contrast, long term capital gains tax rates top out at 20%. As an example, if you hold your investment for more than a year, are single and earn an adjusted income below $39,375 or are married and with your spouse jointly earn less than an adjusted $78,750, you pay no tax at all on your profit.

So all things being equal, the less often you sell, the less you pay in taxes and the higher your investment returns are.

The same is true for any dividends your investments produce. If you hold your qualified dividend (most US and many foreign common stock dividends are qualified) paying common stocks (or funds holding the same) for more than 60 days and qualified preferred stocks for more than 90 days, your dividends will be taxed at lower rates.* So, you increase your return on the dividends you receive simply by holding your dividend paying investments longer.

For example, if you earn an adjusted $38,000 per year and receive a $500 dividend from stock XYZ and sell it before holding it for 60 days, you'll have to pay a 22% tax on it, or $110. Holding that same stock for a full two months will let you keep the full dividend amount, as it'll be tax free.

All bond income is taxed at the regular income rate, regardless of how long you hold the bond or fund. The exceptions are Treasury bonds, whose income payments are state and local tax free, and municipal bonds, whose interest payments are federal, state and local (where you live) tax free.

So how do you minimize your taxes in order to maximize your investment returns? First, try to own as many of your income paying investments as you can in a tax sheltered account like an IRA, 401K, or 457. Second, trade less often in your taxable account. If you never sell anything, you'll never pay taxes on your capital gains. Third, select funds that have low turnover (more on this below) and pay qualified dividends instead of regular income.

Investment Turnover

A third way you pay return killing fees on your investments is turnover in a fund or in a professionally managed account that you own. Turnover is basically the fund or financial adviser who Is investing your money frequently buying and selling investments. There are many reasons why this is bad, but one of the most important is that turnover contributes to both higher commission fees (all those trades the fund does have a cost that lowers the overall return) and taxes (every time the fund sells something at a profit, you have a tax bill).

Owning a fund with high turnover in a tax sheltered account will save you from the resulting tax costs, but you'll still have the regular trading fees damping your returns. It's better to avoid funds with high turnover rates (typically actively managed funds) and stick to passively managed ones. Standard and Poor's did a study in 2017 that found that over the preceding 15 years over 92% of actively managed stock funds underperformed their benchmark. In other words, at most only 8% of non-passive funds did better than the overall index. High turnover was one of the reasons.

Additional Costs of Investing

The below has a summary of other investing costs. They are often harder to minimize because they are harder to quantify. Nevertheless, it is important to be aware of them.

Opportunity Costs

An often overlooked investing cost is that of missed opportunities. A dollar invested in XYZ can't simultaneously be invested in ABC. One way to reduce opportunity costs, or at least to be aware of them, is to have an investment plan, which includes your asset allocation.

Time Costs

Researching various assets and the vehicles by which to invest into them takes time. As with opportunity costs, the time you spend finding new investments and tending to existing ones is time that you can't spend doing other things, like being with your family or friends or enjoying a hobby or starting a side business.

As with opportunity costs, the best way to minimize time costs (unless you enjoy investing research and maintenance) is to set a plan and stick to it. That includes trading infrequently. Another way to minimize time costs is to pay someone else to do your investing for you (see below). Whether it's worth it depends on how much the other party charges for the result you are seeking and how much your time is worth.

Advisory Costs

Advisory costs are fees you pay a professional to advise you about your investments or to invest your money for you. These can come in the form of per session fees, hourly fees, as a percentage of the value of your investments that the advisor is managing for you, a percentage of the investment gains the advisor obtains for you, or some combination of all of these. The percentage based fees are similar to a fund's net expense ratio, except if the advisor puts you into a fund, you pay the fund's fees on top of the advisor's fees.

There are advisors and money managers that are humans, with whom you can meet in person or on the phone to formulate your investing strategy. There are also robo advisors, which rely on technology to advise you and manage your money. Finally, there are services that combine both humans and technology.

If you are a completely hands off investor or someone whose time is very valuable, robo advisors might be something to explore. For a comparatively low fee (usually 0.35% of assets or less), you answer a few questions, deposit your money, and the advisor does all the rest. This includes choosing the best investments for your risk tolerance, periodic rebalancing, and tax loss harvesting (this involves selling investments that you are losing money on and replacing them with similar investments, the end result of which is your overall investment returns are boosted because of a lower tax bill).

One of the most valuable services that investment advisors perform is to talk you out of selling at market bottoms. Many, perhaps most, investors buy high and sell low. It's human nature to get in when things look the best (typically at a market peak) and get out when things look most dismal (typically at a market trough). Advisors' fees can be well worth it if they prevent you from doing this.

Ethical Costs

There may be certain companies, industries, asset classes, or geographical regions that you would rather not invest in because of your moral views. You pay a spiritual cost when you invest in these things, say through a fund. You also pay a potential cost by not investing in things that concern you ethically. That cost is the potential gains you would have enjoyed had you invested in the things you find unethical. The question here is how much are your moral views worth?

* To be more precise, to qualify for the special tax rate, you most hold the qualified paying dividend stock for more than 60 days during the 121 day period that starts 60 days before the ex-dividend date. For qualified preferred shares, it's more than 90 days during the 181 day period that starts 90 days before the ex-dividend date.