Investing doesn't have to be expensive, even though many investments carry onerous fees. Most retail brokers won't advertise low cost options simply because they have no financial incentive to do so. However, as an investor, it would behoove you to take advantage of discount brokerages and free information available through such brokerages. Not only can you do all of the research you need at no cost to you, but the research you do have to do is often very simple. Of course, if you prefer a retail broker, there are a few steps you can take to ensure you're paying the lowest possible management fee.
Examine Expense Ratios and Calculate True Costs
If you decide to go the managed investment route, ask for a statement of fees before you sign on. Even after you get a fee schedule, start with a small investment and wait for your first statement. Your account statement will tell you the total balance of your investment account. This is important because certain financial institutions, like mutual fund companies, are not required to itemize every fee that they charge you. Sometimes, you have to calculate the total cost yourself by subtracting your investment gain and current account balance from your investment principal.
If you are buying mutual funds, you also have the option of asking for the expense ratio. An expense ratio is a mutual fund's operating expenses divided by the average dollar value of its assets under management. The ratio gives you an idea of the total costs associated with the fund. A high expense ratio relative to the performance of the fund means you have a high cost of ownership. In other words, you're paying a lot of money for someone to manage your money for you. For example, if your mutual fund returns 5 percent annually, but has an expense ratio of 3 percent, you are really only making 2 percent annually. This is because the 3 percent expense ratio is deducted from the total investment return of 5 percent. You can probably guess that minimizing the expense ratio is a good idea in this instance.
It's important to understand that a high expense ratio does not automatically make a fund too expensive. You must analyze the fund's cost relative to its performance. A 3 percent expense ratio is relatively low if the fund returns 25 percent to you on an annual basis.
Buy Individual Stocks
If you buy individual stocks, you will usually save money over the cost of a mutual fund if you intend to hold the stock for a long period of time. This is because stocks do not incur ongoing expense charges like mutual funds do. Instead of paying an annual expense charge, you pay a one-time commission for the purchase of the stock and then a one-time commission for the sale of the stock. These transactions are referred to as the ask and bid price, respectively.
Even if you aren't interested in analyzing individual stocks, you can still buy a random collection of stocks and mirror the passive returns of the stock market. In fact, this is what index mutual funds do. The only difference here is that you are cutting out the middle man and saving yourself some money if you have a lot of money to invest.
Buy Low Cost Index Funds
If you don't have a lot of money to invest, or you don't want to take the time to make multiple transactions, or you aren't comfortable managing individual stocks, you can opt for a low-cost index fund. Index funds are a great way to save on investment fees because they track a major stock market index, do not trade heavily on that index, and are often very large and highly liquid (which is a good thing if you ever need to sell off your position).
Index funds do charge you a fee, though it's typically much lower than a managed mutual fund fee. The fund can afford to do this because mutual funds make very few trades during the year. An index fund only buys and sells stock when it sees that there are very poorly performing stocks in the fund that are not recovering or show no signs of recovering. There is no real stock analysis other than monitoring overall performance and auditing individual stock performance periodically. This is why the fund can charge you a low fee resulting in a low expense ratio.
An example of an index fund company would be Vanguard. Vanguard is possibly one of the best known advocates for low-cost mutual funds and provides basic education for investors on how to select funds, how index funds work, and the benefits and disadvantages of index fund investing.
Buy Front-Loaded Financial Products
Many financial products offer several ways to pay for the product. Even bank CDs carry a fee, though this fee is almost never disclosed and is an implicit charge. Banks and financial institutions invest money at one interest rate, and offer to pay you a lower rate on the money you invest with them. The difference between the amount of money the financial institution makes and the amount they pay you as an investor is called the spread. An institution isn't always obligated to disclose how much they are making on the spread since it's an implied fee and not an explicit one.
Another way financial institutions make money is by deferring sales charges. This kind of fee is called a contingent deferred sales charge. Mutual funds, and some other financial institutions, set a graduated fee schedule that decreases over time. In other words, the longer you hold the investment, the lower the fee you pay when you cash out your investment. Many financial products that charge this type of fee eventually reduce the sales charge to $0 after a set number of years. It's important to note that the contingent deferred sales charge is often combined with an annual "load," which is a fee that is charged on top of the deferred sales charge. This is how the financial institution makes money regardless of when you sell your investment.
One way to potentially save money on your investments is to avoid financial products that use a spread or contingent deferred sales charge. Instead, consider investments that are "front loaded." Front loading means that the financial institution charges you a one-time fee up front, or a large fee, with several smaller fees that taper off over the first few years of the investment. While the initial cost is high, the long-term cost with these types of financial products tends to be lower since the fees are charged on a smaller amount of money relative to what you will likely earn in the future.
For example, if you start with an investment principal of $10,000 and a front load of 10 percent, your total cost for the investment would be $1,000. That's a lot, but that's the only fee you will ever pay. If you choose a deferred sales charge that starts at 7 percent and tapers down to 0 percent after 5 years, with an annual load of 2 percent, it would seem like the 2 percent is the better deal if you can wait out the 5 years to escape the deferred sales charge. However, while the first year charge would be just $200, the charge 30 years from now could be astronomical.
Consider the implications if you were to grow your savings to $1,000,000. A 2 percent annual load on $1,000,000 is $20,000, and that's not counting all of the years you pay that fee. Suddenly, the $1,000 front load looks much cheaper.
Whether an investment is expensive or cheap really depends on the total performance potential of the investment relative to the cost. Charging a fee for service is necessary. It's not a necessary evil but a necessary good. You're paying a financial institution to perform a service. Sometimes, it's easy to forget that and focus only on the expense side without considering how much you're getting back in return. If you pay attention to both the investment performance and the fees being charged, you'll have a better idea of the true cost of your investments.