Buying All the Cookies for Less!
In The Beginner’s Guide to Investing – Part 3, we learned that mutual funds are the pre-packaged variety packs of the investment world, and the best solution to guessing which companies are going to grow in value over time is to just own all the companies.
Easy peasy, right?
Well, buying all the companies sure does sound expensive. I’m just starting out and don’t have a lot of money to invest.
Good point. There are currently over 3,000 publicly traded companies in the U.S.
Buying shares of all those companies does sound quite expensive.
But I bet if we take a deeper look at how stocks and mutual funds work, I think we can find a solution.
The first big benefit for average investors like you and me is that many mutual funds offer what are called Fractional Shares.
This means that if they are selling their pre-packaged cookie variety packs for $10 per share, they are willing to sell fractions of shares for a fraction of the price.
For example, we might be able to scoop up 1/10th of a share for $1.
This is a great innovation that has made investing much more accessible to investors starting out with less money.
And while fractional shares are a cost saver that help smaller investors, picking the right kinds of mutual funds can be a huge help as well.
Active vs. Passive Mutual Funds
Mutual funds are created and run by mutual fund companies. (Shocking, I know.)
In general, there are 2 main types of mutual funds: Actively Managed and Passively Managed.
Actively Managed Mutual Funds
Let’s assume our hypothetical LYW Mutual Fund is an actively managed fund.
This means my team and I are actively looking at all different kinds of cookies day in and day out and we’re constantly adjusting the amounts of cookies in our mutual fund based on market conditions.
This sounds great, right?
Analyzing all those cookies means I’ve got a large team of people working in a big office making big salaries.
It also means LYW’s Mutual Fund needs to charge some hefty fees to make money to stay in business, and so my employees can buy vacation properties, Porches, and yachts, oh my!
These high fees may be great for the mutual fund companies, but are horrible for us, the investors.
So Many Ways to Pay for Cookies
While this is a beginner’s guide to investing, I think it’s valuable to take just a quick look at the two main ways mutual funds charge fees.
- A percentage of Assets Under Management (AUM)
- Front Load Fees
Paying a Percentage of Assets Under Management (AUM)
The first way is by charging a percentage of assets under management (AUM). This method charges us a percentage each year of the money we have invested in the fund.
The fees seem really small, generally from 1% to 3% of assets under management. These funds are sold with the idea that the fund is going to increase in value far beyond that tiny percentage so it’s really no big deal.
IT IS A HUGE DEAL.
Over a 20 to 30 year investing period, these “low” fees can peel off hundreds of thousands of dollars from our investment portfolio.
Hundreds of thousands of dollars!
It turns out a fee of even just 1% of assets under management is actually very expensive.
The other problem with Assets Under Management fees is that the mutual fund company makes money from us regardless of whether their mutual fund performs well or not.
Sure, they will earn more money if their fund performs better, so there is at least some incentive for them to try and make that happen, but the truth is that we will be paying fees even when their performance is down and the value of our cookies is eroding.
We need to make sure these AUM (Assets Under Management) fees are as low as possible.
Front Load Fees
The second common way mutual funds charge fees is called Front Load fees.
These mutual funds charge a flat fee on any money that we invest into the fund.
Again, the fees look small, like 1% to 5%, and are sold as being small, but these front load fees are the worst types of fees for 2 reasons.
- These fees don’t even give our money a chance to grow. A mutual fund with a 5% front load fee means that when we put money in, only 95% of it is going to be invested with the opportunity to grow. The other 5% goes straight to the mutual fund company (or to the financial advisor that sold us the funds). That 5% could have been working to make us more money, but instead it’s never even given the chance. Such wasted potential!
- The mutual fund company has very little incentive to perform well. When they make their money on our contribution, it doesn’t matter if their fund makes 10% or loses 10%. They already made their money right up front, and they don’t make more money if their fund performs well. There’s simply no incentive for them to try to do a good job.
Some mutual fund companies have even combined 1 and 2, charging front load fees plus charging an annual Assets Under Management fee.
This is just insane!
RUN AWAY from these funds, and any financial advisors that offer to manage your money using these fee structures.
Many years ago we met with one financial advisor at a local advisory firm here in town, but he only offered funds through American Funds.
When he started showing us what mutual funds he would recommend putting us in, the funds had a 3% front load fee, plus a 1% AUM fee.
That means 3% of every dollar we put in was immediately stripped out and paid to American Funds (or the advisor), plus they were going to charge us an additional 1% of all our assets in their funds each year.
My wife and I took a lot of notes because we didn’t know much about investing at the time. Then we came home and did a ton of research.
We chose not to invest with that advisory firm.
Passively Managed Mutual Funds – The Better Way to Invest
While our team here at LYW’s Mutual Fund are toiling away day and night, another team comes along and decides to start a mutual fund, but they don’t want to hire a large team and work around the clock.
That just sounds exhausting.
So they notice there’s a thing called a Market Index, and there a bunch of them. These market index things are just different lists of companies organized by whatever the index is trying to measure. They are used as measuring sticks to track performance of a certain group of companies over time.
This team sees one index called the S&P 500 Index.
It’s a list of the 500 largest publicly traded companies on the New York Stock Exchange. The list isn’t updated hourly or daily, but only once a year.
This index is a popular measuring stick used to track the health of the US economy over time.
This new team decides to simply create their mutual fund with shares of these 500 companies.
They package it up as a nice cookie variety pack and give it the sexy name The S&P 500 Index Fund. (Catchy, right?)
Then the team goes home. They don’t have to do anything until the list of companies in the S&P 500 index changes the following year.
Since there is no large team hanging around managing this fund day and night, the fee the team charges for this fund is something like 100 times cheaper than LYW’s actively managed mutual fund.
Not 10 times cheaper.
Not 50 times cheaper.
100 times cheaper!
So let’s say my fine team at LYW Mutual Funds was charging 3% of assets under management for our actively managed mutual fund.
This new Index fund would be charging 0.3% AUM.
That is 3 tenths of 1 percent.
That is incredibly cheap.
But Wait a Second. Are the Cheap Cookies Any Good?
Great question, and you’re right to be skeptical.
The financial industry is built around a cacophony of voices telling us that we get what we pay for, and isn’t our retirement nest egg worth spending a little extra for?
It turns out this is largely just marketing.
As we discussed earlier, the problem with those fancy sophisticated mutual fund managers, and the financial advisors who sell their products, isn’t that they’re evil or trying to scam you…although some are, so beware.
The biggest problem is that they are human. Their guesses about the future are rarely better than yours and mine. And research backs this up.
Research over the last 40 years has shown that passive index funds consistently outperform more expensive actively managed funds not by a little, but by a wide margin.
It turns out that for the average investor (you and me) who is looking to invest over a long period of time (10 years or more), the cheaper passive cookie variety packs aren’t just as good as the more expensive managed cookie variety packs, they are better!
Even Warren Buffet knows this.
And a good part of that margin of victory is due to fees.
Remember, those actively managed mutual funds are often 100 times more expensive, stealing away so many of our precious dollars that should be working for us.
When it comes to simple and smart ways to start investing, passively managed index funds are the way to go.
Right now Fidelity has a Total Stock Market Index Fund (FSKAX) that includes shares from over 3,000 companies with an AUM (Assets Under Management) fee of .015% with no minimum amount required to start investing.
In other words, if we only had $20 to invest, we could purchase a fractional share of this fund right now.
That’s a pretty incredible deal.
You’re Almost Ready to Start Your Investing Journey
In the last 4 lessons, we’ve learned that investment accounts are like cookie jars waiting for us to put some cookies inside them.
We’ve learned about the cookies and how we get to own parts of literally thousands of different companies knowing that some of them will be duds and others will be darlings, but we don’t have to know which is going to be which.
And today we learned that price matters, therefore passively managed index funds are the best way to buy lots and lots of cookies at a super low price.
Now let’s jump into Part 5 – our final lesson of The Beginner’s Guide to Investing – to learn the most important skill required when it comes to investing – managing ourselves when things start to look ugly.