Costs: Important Yes, but not the Whole Story

It is fairly well known among savvy investors that costs are one of the main things that can drag down your portfolio’s return over time.  Morningstar.com recently did a study that showed a fund’s expense ratio, relatively to other funds, was a better predictor of performance than their own star system.

This leads many numbers minded people to go on a search for the cheapest, least expensive funds, and them pile them in to their portfolios.  Unfortunately, while this may save on cost, it likely will not bring the desired returns.

The issue that is missed in this scenario, is that the other ingredient necessary in a good portfolio is the right mix.  If investing were like baking, getting right measurements would be like getting low expenses.  Baking, unlike cooking, requires fairly accurate measurements.  So, in investing, being cost conscious is good, and we certainly want to eliminate any unnecessary costs.

However, to complete the analogy, picking the right ingredients (like baking powder vs flour) in baking is like picking the right “asset classes” or investments in your portfolio.  If I made cookies and was perfectly exact in my measurements, but, used salt instead of sugar, or cumin instead of cinnamon, my cookies are not going to be very tasty. That is just like a portfolio with low expenses, but the wrong amount of money in the wrong areas.

Just take the VINIX, the Vanguard S&P 500 Index Fund, Institutional Class.  It’s expense ratio is only .04%.  Wow.  Almost nothing.  However, if you loaded up on that fund 15 years ago, you would have only enjoyed about a 4.62% return per year since then.  I don’t even know if that is better than what bonds did over that time.

Cheap doesn’t always mean good.  It’s important to understand all of the parts needed for a well diversified global portfolio.  Your portfolio’s construction will override the effects of cost every time.