Lessons from an investment legend: Costs matter

Don't let costs shrink your nest egg

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Investing legend Burton Malkiel is the author of the best-selling A Random Walk Down Wall Street — now in its tenth edition, with one and half million copies sold.

He's also a long-time friend of Vanguard founder and index tracker inventor John Bogle, and served alongside him as a director of Vanguard for 28 years.

Prof Malkiel spoke to the Motley Fool UK's office on, amongst other things, the subject of costs.

Costs matter

A reader of The Motley Fool himself, Prof Malkiel knew that he didn't have to spend too long on this particular message.

Here at The Fool, we've long stressed the importance of keeping a careful eye on costs when considering funds and index tracking funds. And on the costs of buying and selling shares, too, of course, in the shape of brokerage fees and spreads.

In short, high costs sap your investing returns.

Even so, we were slightly shocked at the contents of a table that Prof Malkiel shared with us. And we suspect you might be, too.

Dec 94 to Dec 07
annual total return
Latest reported
total expenses
ratio (TER)
Low-cost quartile 8.66% 0.73% 26.4%
Second quartile 8.07% 1.13% 58.3%
Third quartile 7.47% 1.34% 92.7%
High-cost quartile 6.66% 1.88% 209.3%

The table refers to US shares, but we suspect the findings are very similar across markets in other countries, including Australia. After all, the majority of Australian actively managed funds fail to beat the returns of the index.

Study the table, and a few things immediately stand out:

  • The funds with the lowest cost delivered the highest returns
  • The funds with the highest cost delivered the lowest returns
  • The funds with the lowest costs churned their portfolios least
  • The funds with the highest costs churned their portfolios most

In other words, yet again we see that active position trading simply generates additional costs — and uninspiring returns.

Indexing, with a twist

Prof Malkiel goes further, and analyses the distribution of that performance data in some detail. And in simple terms, investment performance is a zero-sum game, he observes: for every investment that outperforms the average market performance, another underperforms it.

But the impact of costs changes the picture. Active management is a negative sum game — in other words, indexing works, and is the best way to achieve market-tracking returns.

Consistently struggle

Some funds will outperform, to be sure — but not consistently. And huge numbers of funds don't beat the market at all, thanks to their costs.

"The active funds that beat the market one year aren't those that beat it the year after, or the year after that," sums up Prof Malkiel.

Indeed, he notes, of the 14 funds that beat the S&P 500 index for nine consecutive years through to 2007, only one managed that same feat in 2008.

The answer? Index trackers, of course. But with a twist.

"I'm a big believer in a strategy of indexing for the core," explains Prof Malkiel. Invest speculatively in individual funds and shares by all means, he urges — but have index trackers at the core of your portfolio.

Have fun…

"Investing is fun," he says. "Telling someone that they can't beat the market is like telling a six year old that Santa Claus is dead. They won't believe you, and they won't want to believe you.

I read The Motley Fool — and if I like an investing idea, I can do it, because the core of my retirement fund is indexed, and so there's much less risk to its overall performance."

And the approach that he describes revolves around what he calls 'satellite' portfolios: actively-managed investments designed to add 'alpha' — or capital growth — to a portfolio, pursuing individual strategies.

The costs will be higher, and the approach requires strong selection skills, but the prospect of market-beating growth is there. Meanwhile, the indexed core protects the overall return.

Timeless investment lessons

And there we have it: timeless investment lessons from an investing legend — and a remarkably courteous and engaging human being as well.

More reading

The Motley Fool's purpose is to help the world invest, better. Take Stock is The Motley Fool's free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it's still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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