One key to maximizing your portfolio returns is to keep your investing costs as low as possible. Yet it can be difficult to figure out exactly how much you're paying for expenses related to your investments, especially if you use mutual funds, insurance products, and other sometimes-less-than-transparent investment vehicles. To help shed some light on a few particularly well-hidden investing costs, we turned to three Motley Fool investing experts to share their experience on expenses you need to watch carefully.
Joe Tenebruso: One of the most often overlooked costs of investing in individual stocks is the time it takes to invest well on a consistent basis. While no amount of time can guarantee good performance, the investors who consistently generate excellent returns often spend countless hours reading and studying businesses.
For many Fools, the time spent studying investments is not viewed as a cost because it's something we enjoy. Still, there is an opportunity cost; we could instead allocate that time to other income-producing or enjoyable activities (like building a part-time business or spending time with family... if you like your family). And if digging through SEC filings and earnings call transcripts isn't your idea of a fun time, the displeasure you feel when spending time on investing-related activities is an additional cost along with the time consumed.
That's why, for the great majority of people, the benefits of dollar-cost averaging into an index fund like the Vanguard 500 Index Fund Investor Class (NASDAQMUTFUND: VFINX) is often the best option. Thanks to their low fees, these funds will allow you to earn a return very close to the market average (which tends to outperform the majority of active investment managers) while keeping your time commitment to a minimum. It's also why if you prefer to invest in individual stocks with the goal of outperforming the market averages, The Motley Fool provides a wide range of free and premium services designed to help you uncover market-crushing stocks while saving you a great deal of the time it would take to try and find these investments by yourself.
Sean Williams: Investors don't often think about the ramifications of choosing a cash account versus a margin account when opening a brokerage account, but the costs of carrying around margin debt can add up quickly, especially for short sellers (investors who bet that stock prices will fall).
Margin, in its simplest form, is nothing more than a loan from your broker. Based on your total account equity, your broker will let you borrow money (for a fee) so you can, in essence, improve your leverage. For example, a cash account with $2,000 allots you the opportunity to buy up to $2,000 in stock, minus commission costs. A margin account, on the other hand, might give you the opportunity to buy $4,000 or $6,000 worth of stock while fronting only your initial $2,000. The well-documented downside is that if a stock, or group of stocks, moves the wrong way, you'll need to add more equity or sell some or all of your position at a loss.
For short sellers, margin is a requirement since they don't effectively own stock in the first place. Margin rates are tied to the prime rate, but they're often numerous percentage points above prime. In other words, it's not uncommon for investors to pay 7%-10% annually on their borrowed money. When you factor in that short sellers' profits are capped at 100% (a stock can't go below $0), short selling can be a downright expensive practice ripe with hidden costs and only modest return potential.
Dan Caplinger: Investors in mutual funds and exchange-traded funds are well aware of most of the expenses that they pay to fund management companies. The well-known expense ratio is designed to show investors the costs they have to pay to have an outside firm manage their money, overseeing the investment process and ensuring that the selections that the fund makes are consistent with the fund's investment objective and produce solid long-term results.
Yet what many people don't realize is that the expense ratio doesn't actually include all of the costs that a fund incurs in the ordinary course of business. Perhaps most importantly, the expense ratio typically excludes the amounts that fund companies pay in brokerage commissions to execute trades. In addition, funds that frequently trade securities often end up losing a substantial amount of money to what's known as the bid-ask spread, which reflects the amount that market makers collect by standing ready to buy or sell shares at all times.
When you add these costs up, you'll often find that funds lose much more of their money to expenses than the expense ratio reflects. Over time, those hidden costs can add up to plenty of lost return and can make the difference between a fund being successful or unsuccessful.