Tuesday, February 5, 2008

Watch Out for MF Expenses!

Mutual funds are one of the most versatile and well-known stock market investment option available to investors. If you are leery of picking individual stocks - mutual funds are the option many investors gravitate towards. The first challenge you face when considering mutual funds is the number and variety of options available. Lets assume you have done your homework and picked the right mutual funds for your portfolio. Then what you need to worry about are the expenses associated with your mutual fund picks?

If you want to know more about the way mutual fund expenses work - visit this site. What got me all worked up was the long-term impact expenses or fees have on portfolio return.

Here is what I am talking about.

Scenario A: I invest $10,000 and get a return of 10% every year (ignore the current market sentiment for this example). My total fund fee is 2% per year.

Scenario B: I invest $10,000 and get the same return of 10% every year but my total fund fee is 0.5% per year (Vanguard 500 Index Fund has an expense ratio of 0.15%).

So how do the numbers stack up?

In 10 years - Scenario A portfolio will be about $21.5K and Scenario B portfolio will be $24.7K. In this time period you will also pay about $2000 in absolute fee expense and $3200 less in compounded growth, effectively reducing your earning potential by 15%.

In 20 years - Scenario A portfolio will be about $46K and Scenario B portfolio will be $61K. That translates into $6000 paid in fees and $15000 less of compounded growth. Your setback - about 30% less growth.

In 30 years - Scenario A will return $100K versus a return of $150K in scenario B. Fees will add up to about $7500 but here is the magic of compounding. Your overall portfolio growth is impacted to the tune of 50% or about $50K less.

You cannot do away with mutual fund expenses but the more you can minimize them, the more your money works for you.

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