An easy way to increase your investment returns is to pay more attention to the expenses you are incurring. Even seemingly small savings can result in a notable increase in your long-term profits. More importantly, every dollar you save in expenses is a dollar increase in your net worth.
Keep in mind, however, that investing involves finding a balance between the potential for making money and the potential for losing money, and expenses are no different. This is why you should always compare the costs you incur against the value you are receiving.
In some circumstances, higher expenses may be warranted. In others, they are an unnecessary transfer of wealth out of your portfolio.
I recommend reviewing all of your investing expenses on an annual basis. There are five primary areas to look at: brokerage commissions, taxes, trading costs, fund fees and advisory/custodial fees.
Brokerage commissions – These are the fees you pay to buy or sell a security. In general, lower fees are better, though you should consider the other services provided by the brokerage firm. For example, it might be worth paying a few extra dollars per trade if the brokerage firm provides good research, access to useful online tools, or offers certain conveniences that you find to be of value.
Taxes – Capital gains and dividend taxes reduce the actual profit you realize. Though the new tax law extends low rates, taxes still lower your true return. Short-term capital gains are even more expensive. Whenever possible, hold your least tax efficient investments (e.g. dividend-paying stocks) in your IRA and your most tax efficient investments (e.g. municipal bonds) in your regular brokerage account.
Trading Costs – Also referred to as transaction costs, these are expenses incurred when a buy or sell order causes a security’s price to move. Trading costs are extremely low for an actively traded stock such as General Electric (GE) and are higher for a stock or bond that is not actively traded. In all cases, you should consider the average daily dollar volume (total number of shares times price per share) and how much money you are looking to invest.
It may be more profitable to place several small orders rather than one large order. You should also use limit orders to ensure your transaction is executed within the bid-ask spread (the price buyers are willing to pay and the price sellers are looking to receive).
Fund Fees – Both mutual funds and exchange-traded funds (ETFs) charge annual management fees. Mutual funds may also charge fees for buying (front load) or selling (back-end load) shares, as well as fees for marketing expenses. Since most mutual fund managers do not beat their benchmarks (e.g., the S&P 500), lower fees are preferable.
As far as ETFs are concerned, the free trading commissions offered by brokerage firms may not be justified if the annual expense is higher than a similar ETF that does not qualify for the waived commissions. Be sure to consider both the risk-adjusted performance and the diversification benefits a fund offers; a higher fee may be justified if a fund provides less volatility or allows you to invest in an asset class you are not already invested in.
Advisory/Custodial Fees – Some firms charge advisory, custodial or account maintenance fees. You may also pay separate expenses to consult with a financial advisor. These expenses can be justified if you are receiving quality advice, lower commissions, or provided access to other financial services. The more complicated your financial or tax situation is, the more you will need to spend on advisory fees. Furthermore, a good advisor is worth the expense if he can keep you on track to achieve your financial goals.
As stated above, you should review your investment expenses annually to determine whether you are receiving adequate value for them. In my book, Better Good than Lucky, I recommend keeping a trading journal that lists the reasons you bought and would consider selling the stocks, bonds and funds you hold in your portfolio. It is also a good idea to include a list of your investment fees and the reasons you think they are valid. Doing so will provide a checklist that can assist with your annual review. It’s simple, but very effective.