A Terrible Investment That Could Cost You $91,621

Worldwide Invest Better Day 9/25/2012

Successful investing often involves compounding your money over the course of decades. Therefore, losing money, even small amounts, can make a big difference over time.

As the scenario I'm about to present shows, being aware of where you might be losing money could easily mean the difference of tens or even hundreds of thousands of dollars. I don't know about you, but that's money I'd much rather have in my account.

A startling email
Improved 401(k) disclosure requirements now require more paperwork of 401(k) participants. While there is some very useful data contained in the documents, for many 401(k) investors, the new data may seem barely more than gibberish. As a result, I've received emails from family members with these documents and the message, "Can you tell me what this means?"

Earlier this week, I received one such email and began sifting through the investment options offered by that company's 401(k) plan. What didn't surprise me was the fact that a great many of the actively managed mutual funds had underperformed their benchmarks. In fact, around two-thirds of such funds have been shown to underperform indexes like the S&P 500 (INDEX: ^GSPC  ) . What likewise didn't surprise me was that the fees on these funds were high -- many of them greater than 1% per year.

What shocked me, however, was what I found when I tracked down the index funds offered in the 401(k) plan. For friends and family members who don't have the time or inclination to do the research necessary to invest in individual stocks, I typically recommend index funds. They guarantee that you won't beat the market, but you won't drastically underperform the market, either. They're also typically low-cost.

But "low-cost" is not how I would describe the index funds in this plan. The cheapest fund available was the S&P 500 index fund, which carried a 0.53% annual fee. While that's low compared to the actively managed funds in the plan, with their 1%-plus fees, it's egregiously high compared with the standard-bearer of the index fund world, Vanguard's S&P 500 index fund. That fund sports an annual fee of just 0.17%.

Does that difference matter? You bet it does. Just take a look at the difference it makes over time for a $100,000 starting investment.

Source: Author's calculations. Assumes 8% annual growth.

To put that in numbers, the 401(k) plan index fund costs $360 more on the $100,000 portfolio in the very first year. Over 10 years, the difference in portfolio values balloons to $6,989. At year 20 we're up to $29,219. Over the course of three decades, the portfolio with the Vanguard index fund has $91,621 more than the portfolio with the 401(k) version of the index fund. Imagine what that difference could mean to your retirement.

Now as you think about the outperformance of the Vanguard fund, bear in mind that these are essentially the exact same fund. Both funds are designed to do the same thing: passively mirror the S&P 500 index -- no more, no less. The difference over time is due 100% to the difference in fees.

Simple math
Trying to generate outperformance by being smarter than other investors and picking the right stocks is exceedingly difficult. It takes time, focus, patience, and persistence, and even then the cards may not fall your way.

On the other hand, minimizing the fees that you pay is simple math. When you can find funds that meet your investing objectives and carry lower fees, you can make sure that more money -- potentially a lot more money -- stays in your portfolio, compounding over time and helping you meet your retirement goals.

While the comparison above is stark enough, the advent of exchange-traded funds has given investors even lower-cost ways to diversify their portfolios. Here are just a few such examples from Vanguard:

Exchange-Traded Fund

Objective

Annual Fee

Vanguard S&P 500 ETF (NYSE: VOO  ) Mirror the returns of the S&P 500 Index 0.05%
Vanguard Dividend Appreciation ETF (NYSE: VIG  ) Mirror the returns of the Dividend Achievers Select Index 0.13%
Vanguard Total Stock Market ETF (NYSE: VTI  ) Mirror the returns of the MSCI US Broad Market Index 0.05%

Source: Yahoo! Finance.

What you can do
If you're investing on your own, the objective is clear: When investing in funds, seek out those funds that meet your objectives at the lowest cost possible. That's easy enough, right?

When you're in a 401(k) plan with lackluster investment options -- like my family member above -- it can get a bit trickier. That said, you're not the only employee at that company getting hurt by the high-fee investment options available. If your co-workers realized that their retirement portfolios were being hacked up by high fees, they'd likely want better options as well.

At the same time, the well-meaning folks in your human-resources department may not even realize how bad the fees are in the company's 401(k) plan. If you bring this to their attention (tactfully), they may be very keen to find a better option.

If this is your situation, you're in luck, because my fellow Fool Dayana Yochim has cooked up an excellent customizable letter that you can use to present this dilemma to whoever handles the 401(k) at your company. You can find that letter here.

Invest better!
Being mindful of high fund fees are exactly the kind of tips that The Motley Fool is doling out in spades as we head toward the first annual Worldwide Invest Better Day on Sept. 25. To learn more about the big day, just click the bar below.

Fool contributor Matt Koppenheffer owns shares of Vanguard Dividend Appreciation ETF, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (3) | Recommend This Article (16)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 15, 2012, at 4:12 PM, xetn wrote:

    Question: Why start at a portfolio of $100,000.00?

    How many people have a portfolio of that amount in a 401K?

    Just asking.

    Starting at $10,000.00 for example, and all things equal, after 20 years the extra cost would be $2,921.90. Still a lot of fees.

  • Report this Comment On September 15, 2012, at 8:54 PM, 48ozhalfgallons wrote:

    Thanks, xetn for getting us down to Earth here.

  • Report this Comment On September 17, 2012, at 12:58 AM, lowmaple wrote:

    In reality you may statr at $10000 but you probably would keep adding if you had the means and the portfolio would get to way over 100,000. This example obviously is more impressive at a higher amount.

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