I started this investing study seeking to find out why my professionally managed investments are outperformed by unmanaged indices of the stock market (e.g. the DOW). In this chapter, I believe we uncover the dominant reason and the most important single paragraph of his book. With the foundation complete, in the three chapters that follow, we will see Malkiel’s strategy for beating managed funds.

Malkiel’s Rule 7: Pay Yourself Not the Piper

This chapter focuses on the costs of financial services. In his opening paragraph, he makes the point that over the long haul “the sales charges and ongoing expense you pay will hake a dramatic difference in the cumulative value of your portfolio.”  He says that these costs can be about 2% a year.

An illustration of why this matters: If over the long haul your investments make 8% a year (as stocks have done over the long haul), these costs will effectively reduce your net rate of return from 8% to 6%. Now remember the rule of 72. Instead of your money doubling over 9 years, it will take 12 years.  Suppose you invest $1,000 over 40 years. At 8%, this amount will grow to $21,725; at 6%, it comes to $10,286 instead. His conclusion: costs matter.

He warns that many financial services companies obscure their costs. He quotes the former chairman of the Vanguard Companies, “A low-expense ratio is the major reason why a [mutual] fund does well…the surest way to top-quartile returns is bottom-quartile expenses.” He says that most mutual funds turn over their entire portfolio in a year, adding transaction costs to the management expenses they charge.

So you need to look for funds with low expense ratios.  He advises against mutual funds with a load charge. He says the situation it the same with bonds and money-market funds, costs matter.

“Every extra dollar of expense you pay is skimming form your investment capital. Those funds are lost forever.”

So here is the most important paragraph of the book (so far at least) in my opinion:

In rules 8 & 9, I will recommend broad-based stock and bond index funds as the preferred investment vehicles of choice. Of all the funds offered in the market, index funds have the lowest expense ratios. Moreover, index funds mangers are fundamentally “buy and hold” investors. Thus, they avoid the transaction costs that are associated with funds that trade from security to security and regularly turn over the holdings in their portfolios. But even with index funds, expense ratios vary among mutual fund companies. You can be an educated consumer by learning about expense ratios from the Morningstar Mutual Fund Service (www.morningstar.com) and the Securities and Exchange Commission (http://www.sec.gov/investor/tools/mfcc/mfcc-int.htm). Don’t let high fund expenses eat up your retirement funds.

 Finally he says that cost matter in all financial products.

• He cautions against buying insurance via variable annuities and whole life policies as they are in essence mutual funds with a costly insurance wrapper.
• He suggests if one wants to buy stocks directly, to look for a discount broker (but make sure you know what you are doing and you get an honest broker belonging to the Security Investor Protection Program).
• He also has a strong caution against something called a “wrap account” as they cost can be very high.

Next time: Rule Eight: Bow to the Wisdom of the Market

The above is from my on-going study on investing, from Malkiel’s The Random Walk Guide on Investing. For more, see my summary.