‘What is the single most effective piece of financial advice you’ve ever received?’ Max out your 401k and start early. Invest in Mutual funds with a low expense ratio.
When I signed up for my first 401k, I spent hours pouring over thick prospectuses, attempting to outsmart the market and pick “the best and smartest” fund.
I was working for an investment bank, so I also consulted my highly esteemed — and highly-paid — colleagues.
In public they prioritized:
- Past performance: 1-year, 3-year, 5-year, 10-year returns
- The glitziness of the fund manager: their background, current firm, top picks, affiliations, and brand
- The type of investment the funds made: were they in the hot markets of technology, dot-coms, healthcare, and real estate?
However, one colleague gave me the most effective piece of financial advice, look at the fund’s Expense Ratio. The expense ratio does not include the cost of buying a fund. This expense is referred to the sales load fee, and is a one-time event.
The expense ratio represents the percentage of the fund’s assets that go towards the expense of running the mutual fund. The expense ratio covers:
- investment advisory fee
- administrative costs
- 12b-1 distribution fees
- other operating expenses
With an expense ratio of 1%, a mutual fund is paying itself 1% of the total money in the fund every year, irrespective of how the fund does. Even if the fund loses money, you will be out the expense ratio. So, typically the higher the expense ratio, the lower your return.
It is tempting to look at past performance, or brand of the fund, as this can be an effective strategy in predicting many things in life. However, there is little evidence that investing in funds that have performed well in the past is a good strategy to pick those that will do well in the future.
There are hundreds of funds out there and roughly half outperform the market and half underperform the market over any period of time. By sheer chance, there are going to be some outliers that have done incredibly well and the ones that performed terribly will disappear (leading to a bias if you only evaluate funds that currently exist).
There is little to evidence that any given fund that has outperformed the market will continue to do so. However, there is a lot of evidence that a high expense ratio fund will result in higher expenses and lower returns than one with a lower expense ratio.
Also, as Marie Stein rightly mentions in the comments: “keep in mind though, that some funds also charge front-end sales loads, back-end sales loads, and/or redemption fees. For instance, a fund might have a low annual expense ratio; but a sales load on the front end, or redemption fees and loads on the back end which may nip into your returns.”
This article first appeared on Quora.