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How much does your mutual fund cost?

toothpasteI recently watched a Ted talk by Dan Gilbert that I can best describe as an entertaining combination of Nudge, Predictably Irrational, and Against the Gods.

One of the things Dan talks about is that, as humans, we’re not very good at judging value. We have a tendency to judge the value of something simply by comparing it to something else in the near vicinity.

One of the examples Dan used to illustrate his point was the following:

People don’t know whether their mutual fund manager is taking 0.1% or 0.15% of their investment, but they clip coupons to save $1 off their toothpaste.

So true! The average shopper has some idea of what a tube of toothpaste costs. If the price were to drop by $2, we’d notice and perhaps buy a couple extra. If the price were to go up by $2, we might buy another brand instead.

In contrast, the average investor has (I suspect) absolutely no idea what he’s paying for his mutual funds. I imagine this is caused by two factors:

  1. Fund expense ratios are hidden away in rarely-read prospectuses, and
  2. Mutual fund expense ratios just aren’t something that most people spend time thinking or talking about. (But would it really be so strange to bring it up? I mean, people mention it to their friends when they “save” $15 on a pair of jeans, right?)

Price Inelasticity

Economists refer to a good/service as having inelastic demand if consumers continue to buy it at roughly the same rate even when the price increases. The most common example of an inelastic good is insulin. Even if the price of insulin goes up, the people who need it will keep buying it.

It appears that mutual funds prices are fairly inelastic. Sadly, this isn’t because mutual fund managers provide some all-important service.  Mutual fund demand is inelastic simply because people don’t know what they’re paying.

How many people are paying an extra 1% each year without even realizing it, completely unaware that it will cost them hundreds of thousands of dollars over their investing lifetime?

Fortunately, the rise in index fund popularity over the last couple decades might suggest that mutual fund prices are slowly becoming more elastic as investors catch on to the impact of costs on long-term investment results.

Takeaways

First: regardless of which funds you decide to invest in, make sure you at least know what you’re paying for them.

Second: switching to low-cost index funds will save you enough money to buy a lot of toothpaste over a lifetime of investing.

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Comments

  1. We had a mutual fund that was charging 2%, because it was managed by “one of the top people in the industry”. After I really looked at the fund, and what we were paying (not to mention the slightly below average returns), I switched out and never went back to managed funds. Learning from experience. But an experience that I wish I’d never had. I wasted good money for almost five years on that fund.

  2. Hehe… inelasticity b/c of stupidity/ignorance =D

    I think the best way to think abt it is that the past performance tells you nothing about the future performance; the only thing that you know for sure is cost (they don’t flucuate… that much …) sooooo is it worth it?

  3. Miranda: Ouch. Better late than never though. (And as investing mistakes go, that’s hardly the worst one a person could make!)

    SJ: Goodness, I hadn’t meant to imply stupidity. Ignorance, yes. (Just the denotation, not any negative connotations.) I really do suspect that most people simply have no idea what they’re paying. And even if they did, I suspect most would have no idea how that compares to any other options.

    And I like the way you put it: Costs stay (mostly) the same. Performance fluctuates. So which should we bet on? 🙂

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