Tuesday, August 24, 2010

1% Makes a $9,000 Difference

In a previous article, I talked about how expensive mutual funds often have worse returns than cheap ones.  You might think that a fund that costs you an additional 1% per year really isn't that bad.  We're only talking about 1% after all, right?  However, if you compare two hypothetical funds that have identical returns, but where one is cheap (0.5% in expenses per year) and one is expensive (1.5% in expenses per year), that 1% per year difference adds up.

Below shows a comparison of what would happen if you invested $10,000 in a cheap fund versus an expensive fund where both funds earn 5% per year:

Start1 Year5 Years10 Years20 Years30 Years
Cheap Fund$10,000.00$10,450.00$12,461.82$15,529.69$24,117.14$37,453.18
Expensive Fund$10,000.00$10,350.00$11,876.86$14,105.99$19,897.89$28,067.94
% Difference0.00%0.97%4.93%10.09%21.20%33.44%

As you can see, that additional 1% per year expense erodes your investment returns significantly over time.  After 30 years, you've just given away over $9,000. 

The only way it makes sense to invest in the expensive fund is if that fund returns you an extra 1% in investment returns in order to compensate.  However, as Moringstar has shown, expensive funds rarely outperform cheap ones.

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