FOOL ON THE HILL: An Investment Opinion
The High Cost of "Helpers"

Investors cannot get anything out of investing in businesses over the long term except the profits the businesses themselves earn -- minus the actual costs involved in investing in those business. With the aggregate frictional costs of investing in this country approaching $130 billion annually, it's time to take a long, hard look at what we spend our money on.

Format for Printing

Format for printing

Request Reprints


By Bill Barker (TMF Max)
October 30, 2000

This classic Fool on the Hill column originally ran on November 4, 1999.

Last week in this space I looked at a particularly indefensible example of what is wrong with Wall Street analyst reports. I notice that last Friday the analysts in question reiterated their rating of "Strong Buy/$30 Price Target" for (Nasdaq: TSCM), which had initially triggered my ranting. Given their action, I am forced to reiterate my rating of "Short-term: Silly/Long-term: Intellectually Dishonest" as to their use of numbers.

I mention this only because at the heart of what I wrote last week was a deep dissatisfaction with the habit of some to bend, fold, spindle and/or mutilate numbers in their analysis in a way that is not really acceptable. As a counterpoint to this type of numbers-abuse, Fortune has published a particularly interesting reconstruction of some recent speeches by Warren Buffett -- and when Buffett speaks, Fools listen. (Or read, as the case may be.)

There are a lot of good bits to focus on in Fortune's piece, and I'm confident that in the days to follow, other Fools are going to be covering various aspects of the speech. Most likely to be given cyber-ink is Buffett's analysis that the real rate of return on equities over the next 17 years is likely to be about 4% annually. While the numbers behind his explanation for that are quite enlightening, for today I'd like to look at what Buffett has to say about the current costs of investing.

Buffett points out, for those who have forgotten, that investors cannot get anything out of investing in businesses over the long term except the profits the businesses themselves earn. Actually, investors can ultimately realize no more than what those businesses earn minus the actual costs involved in investing in them. Here we're discussing simply the "frictional" costs involved in buying and selling equities, and of purchasing advice from "helpers" (Buffett puts the word in quotation marks), such as full-service brokers and mutual fund managers.

Buffett figures the costs are comprised of essentially three components:

  1. The transaction costs of buying and selling shares, the market maker's take, and the spreads on the underwritten offerings. Buffett sees the average cost of trading a share to be about six cents, to the buyer and the seller each, and that with 350 billion shares to be traded this year, a total cost of about $42 billion.
  2. The costs of owning mutual funds, about 1% of assets annually. With approximately $3.5 trillion currently in equity mutual funds, an aggregate cost of $35 billion.
  3. The additional costs of options and futures, and the very deep costs borne by holders of variable annuities. No specific figure is given.
Ten billion here, ten billion there -- pretty soon it all starts adding up to real money. According to Buffett, the costs of investing in this country amount to about $130 billion annually.

The power, in part, of Buffett's recitation of these numbers is that if you know a little about them, Buffett is in no way overstating his case. For instance, the Investment Company Institute, the lobbying group for the mutual fund industry, computes the annual costs of mutual fund ownership to be 1.49%, a full half percent above the figure Buffett uses. So Buffett isn't trying to drive his numbers up -- he's being quite cautious in his estimations.

But getting at the highest total cost that could be computed is by no means necessary to support the ultimate point. $130 billion after all should be enough to serve the argument. According to Buffett, this is "a horrendous cost. I heard once about a cartoon in which a news commentator says, 'There was no trading on the New York Stock Exchange today. Everyone was happy with what they owned.' Well, if that were really the case, investors would every year keep around $130 billion in their pockets."

What I wanted to understand, after reading that, was basically -- just how much is $130 billion anyway? I mean, you read a lot of numbers in the course of your day or your life as an investor, and it's pretty easy to get numbed to the meaning of one REALLY, REALLY big number vs. another EVEN BIGGER number. So, let's take just a few moments to step back and look at about how much is falling out of investors' pockets every year.

$130 billion is about the size of the market capitalization of the twentieth biggest company in America. Companies that today would cost around $130 billion to buy at their current market caps would be:
AT&T                $152 billion
Pfizer              $151 billion
Johnson & Johnson   $146 billion
Coca- Cola          $141 billion
Procter & Gamble    $141 billion
Home Depot          $112 billion
Berkshire Hathaway  $112 billion
Dell Computer       $107 billion
So investors are spending nearly as much to keep the stocks they have (or change them around a bit) as it would cost to buy the entire company of Coca-Cola. Every year. Investors manage to drop something between a Home Depot and an AT&T out of their pockets every turn around the sun.

Maybe that doesn't help you envision how much $130 billion is any better. After all, closing your eyes and picturing "a Pfizer" coming out of somebody's pocket might just seem silly to you. (Or even vaguely illegal.) So let's approach it a different way. I checked out the proposed budget for Our Government for Fiscal Year 2000 to help me get a grip on just how much $130 billion is. The government is, after all, generally accused of being just about the most profligate spender around. One would assume that prudent investors get more out of their money than the government does, right?

$130 billion is:
  • Seven times as much as our government annually spends on science, space, and technology.
  • More than two and a half times what our federal government spends on education, training, employment, and social services.
  • Six times the budgeted amount spent to protect the environment, manage Federal land, conserve resources, provide recreational opportunities, and construct and operate water projects.
  • Nearly two-thirds of the amount spent on Medicare.
I'll give you another way to gauge the amount, one which might strike closer to home. Figures have been quoted in the press lately that nearly half of all Americans are invested in the stock market in some manner. That amounts to roughly 130 million individual Americans -- so on average each American who is invested in the market is paying $1000 a year in costs. The average invested middle-class family with 2.3 children, is therefore spending $4300 a year on annual equity investment costs. That's akin to adding over $350 a month onto the mortgage -- and getting essentially nothing in return.

That last set of figures ignores the percentage of that $130 billion borne by foreigners investing in our markets, but then again, I'm not figuring in the costs of investing in bonds or bond funds, and there's about a trillion dollars currently invested in bond funds. I think my numbers are fair -- but say I'm off by a factor of 100%. Then it's still the case that the average American family is paying over $2000 a year in investment costs.

At any rate, $130 billion is a lot, or, putting it another way, it's way too much. Now, no one is going to argue that all of these costs can ever be eliminated. Even index mutual funds must impose some cost, though it is about one-eighth the annual costs of managed funds. And there does need to be some small cost involved in buying or selling stocks, even for buy-and-hold investors. And some people (a very few) are perhaps even better off paying for the advice of a professional money manager. But well over half of these costs could be eliminated simply with improved education about them. And that education is not going to come from Wall Street.

If Buffett is right that the average annual real rate of return on stocks over the next 17 years is likely to be about 4%, then it will become absolutely crucial that investors cut out the expensive middlemen inserting themselves between investors and their holdings. When the market is going up by 20% per year, as it has been doing of late, then 1% or 2% won't seem to mean all that much. But if, as Buffett postulates, we're in for some substantially diminished returns in the future, it is going to be essential to be a low-cost investor to realize much of anything from the stock market.