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In this episode of Investment Strategy Made Simple (ISMS), Andrew gets into part two of his discussion with Larry Swedroe: Ignorance is Bliss. Today, they discuss two chapters of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this eleventh series, they discuss mistake number 20: Do You Only Consider the Operating Expense Ratio When Selecting a Mutual Fund? And mistake number 21: Do You Fail to Consider the Costs of an Investment Strategy?
LEARNING: Don’t focus solely on the operating expense ratio when buying a mutual fund; consider hidden costs, too. Always consider the costs of an investment strategy, such as bid-offer spreads, market impact costs, taxes, etc.
“Successful active management, as I like to explain it, sews the seeds of its own destruction.”
In this episode of Investment Strategy Made Simple (ISMS), Andrew gets into part two of his discussion with Larry Swedroe: Ignorance is Bliss. Larry is the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.
Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss two chapters of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this eleventh series, they discuss mistake number 20: Do You Only Consider the Operating Expense Ratio When Selecting a Mutual Fund? And mistake number 21: Do You Fail to Consider the Costs of an Investment Strategy?
Did you miss out on previous mistakes? Check them out:
- ISMS 8: Larry Swedroe – Are You Overconfident in Your Skills?
- ISMS 17: Larry Swedroe – Do You Project Recent Trends Indefinitely Into the Future?
- ISMS 20: Larry Swedroe – Do You Extrapolate From Small Samples and Trust Your Intuition?
- ISMS 23: Larry Swedroe – Do You Allow Yourself to Be Influenced by Your Ego and Herd Mentality?
- ISMS 24: Larry Swedroe – Confusing Skill and Luck Can Stop You From Investing Wisely
- ISMS 25: Larry Swedroe – Admit Your Mistakes and Don’t Listen to Fake Experts
- ISMS 26: Larry Swedroe – Are You Subject to the Endowment Effect or the Hot Streak Fallacy?
- ISMS 27: Larry Swedroe – Familiar Doesn’t Make It Safe and You’re Not Playing With the House’s Money
- ISMS 29: Larry Swedroe – The Shiny Apple is Poisonous and Information is Not Knowledge
- ISMS 30: Larry Swedroe – Do You Believe Your Fortune Is in the Stars or Rely on Misleading Information?
Mistake number 20: Do you only consider the operating expense ratio when selecting a mutual fund?
According to Larry, a lot of investors are aware that there is at least some relationship between expense ratios and returns of mutual funds. Sadly, too many people ignore that because they believe that active management will likely add value despite the evidence against it.
Further, many investors only consider the operating expense ratio when selecting a mutual fund. Larry says this is just one of many costs associated with investing and often not the most significant. He emphasizes that investors should look out for other hidden costs, such as:
- The “cost of cash” – when a fund holds cash instead of being fully invested.
- Trading expenses such as commissions and market impact costs.
- Taxes on gains.
These costs can significantly impact returns, with high turnover and tax inefficiency leading to lower after-tax returns. So, don’t focus solely on the operating expense ratio.
If you’re trying to decide whether to buy an ETF or a mutual fund, Larry says the rule is for a taxable account: buy the ETF because it’s more tax efficient. If you’re in a tax-advantaged account, buy the mutual fund because you don’t pay a bid-offer spread, and you don’t care about the tax efficiency in the fund. Also, if you’re going to buy an ETF, don’t trade first thing in the morning or last thing at the end of the day. You can get really screwed by price movements. Trade at the middle of the day.
Mistake number 21: Do you fail to consider the costs of an investment strategy?
Investors are often drawn to market-beating investment strategies but should exercise caution. Larry notes that when you see returns on a strategy, they often don’t include costs. What you usually see is a strategy that encourages you to buy stocks by looking at the day’s closing prices. Then, you sell at the closing price later. Such a strategy ignores bid-offer spreads, market impact costs, taxes, etc. Moreover, implementing such a strategy incurs costs that can erode your returns.
Larry adds that most people think that the past performance of active funds predicts future performance. As successful funds see their assets under management (AUM) grow, investors might think it’s a good sign. However, research shows there are diseconomies of scale in active management because the bigger the funds get, the higher their market impact costs go. Therefore, you should always remember that past performance does not always indicate future success, and some strategies may be based on luck rather than skill.
About Larry Swedroe
Larry Swedroe is head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.
Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.
Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.