Investing without Wall Street: The Five Essentials of Financial Freedom

CHAPTER 4

The Fourth Essential: Keep Your Costs Low

It's vital to keep your costs low. Studies done by Morningstar, Vanguard, myself, and many others show that the lower the expenses, the better the long-term performance. In fact, fund expenses predict performance better than any other single factor. That's because over-head expenses directly reduce performance. Low expenses foster good performance; high expenses reduce performance. This is the key reason why index funds do so well.

A corollary to this rule is that while good performance doesn't always continue, poor performance more often does. When poor performing mutual funds have higher expenses, funds find themselves in a vicious cycle. Alert shareholders bail out of these funds. The asset base shrinks but fixed costs stay the same, which drives up per share expenses. The performance worsens; more shareholders redeem. The cycle continues.

It can get pretty bad. Back in the 1990s there was a group of funds called Steadman Funds, later renamed the Ameritor Funds. Ten thousand dollars invested in their American Industry Fund at the beginning of the decade declined to $6,500 10 years later. Mind you now, this was the 1990s, a great decade for huge gains. It was virtually impossible for a fund to lose over a decade in this bubble—but Steadman did it.

With most investors redeeming, assets declined to $900,000. The expense ratio rose to 29.9 percent versus an industry average of about 1.5 percent. The prevailing opinion in the fund ...