What Wall Street Doesn’t Want Investors to Know

The recent sharp market decline has brought out the worst in the securities industry and the financial media. Some brokers and pundits who were “riding the bull” have undergone a remarkable transformation and now advise “fleeing to safety.”

The financial media fed the frenzy by interviewing an endless stream of commentators who tell us the decline is either a temporary lull or the beginning of a massive market correction. Their explanations are filled with rationalizations. This nonsensical observation from David Lafferty, the chief market strategist for Natixis Global Asset Management, is typical. He says, “The market really needs some time to digest last year’s gains.”

A recent column by financial columnist Chuck Jaffe summarized the conflicting prognostications of various “experts” and correctly concluded: “Only a moron would act on forecasts.”

Fortunately, there is information readily available to investors that they can rely upon, but it is not served up in sound bites by the financial media. This information is dull and dry. It doesn’t stoke fear, anxiety or greed. It’s disseminated without an agenda other than to educate. It’s timeless, irrefutable advice that does not change with the markets. It is especially important to revisit this advice when the markets are volatile and the media is whipping up a frenzy.

John Bogle, founder and former chief executive of The Vanguard Group, is one of these few sources. He wrote one of my favorite books on investing, “Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor.”

On Feb. 10, 2005, Bogle gave a talk at a conference of the Financial Analysts Journal in Pasadena, Calif. He focused on the one issue Wall Street wants you to ignore. It’s an issue you need to understand if you want to be a successful and responsible investor: costs.

In his talk, Bogle articulated what he called the “cost matters hypothesis.” He expressed this as, “Gross return in the financial markets, minus the costs of financial intermediation, equals the net return actually delivered to investors.” No one could quarrel with that equation. Bogle stated that you can ignore the debate about markets being efficient or inefficient. It really doesn’t matter. He considers the proposition that investors as a group must fall short of market returns by the amount of costs they incur as the “central fact of investing.”

The ramifications of the cost matters hypothesis are sobering. If your goal is to beat the markets – relying on the stock picking, market timing and fund manager-picking advice of your broker – you might want to rethink your strategy. Examples of costs you will need to overcome in your quest to beat the market are advisory fees, marketing costs, sales loads, brokerage commissions, legal and transaction costs, custody fees and securities-processing expenses. That’s a tall mountain to climb if your goal is to outperform the average investor.

How tall? Bogle recently updated his analysis of the pernicious effect of costs on market returns in “The Arithmetic of ‘All-In’ Investment Expenses,” published in the Financial Analysts Journal. He calculates the difference in the cost of actively managed funds and index funds as a whopping 2.21 percent, when you consider management fees (also called expense ratios), transaction costs, cash drag and sales charges/fees.

The securities industry is adept at hiding the significance of fees by stating them as a percentage of asset values. Bogle notes that, assuming a 7 percent market return, the 2.27 percent difference between an actively managed fund and a comparable index fund would account for almost 33 percent of your return. In stark contrast, the far lower cost of the index fund (0.06 percent) would reduce returns by less than 1 percent.

Over time, this wide disparity in costs can make a serious difference in the amount accumulated for retirement, ranging from a difference of 13 percent after 10 years to a 65 percent enhancement in capital after 40 years. Bogle’s calculations assumed a 7 percent nominal annual return on stocks.

When taxes are taken into consideration, the mountain gets higher. Bogle assumed a stock market return of 7 percent for the 10-year period ending April 30, 2013. The assumed net return of an actively managed fund after taxes and costs was 3.98 percent. The return for comparable index funds was 6.64 percent, representing a difference of 2.66 percent.

In dollar terms, this difference is staggering. A $10,000 investment at the beginning of this period would have grown to $48,000 after tax in the active fund. The index fund investor would have accumulated $131,000, a difference of $83,000, or almost 175 percent. Bogle notes, “Taxes are a vital consideration.

Bogle’s takeaways include:

• Think about the long term.
• Recognize the massive impact that costs and taxes have on your retirement wealth.
• Follow this warning: “Do not allow the tyranny of compounding costs to overwhelm the magic of compounding returns.”

In good times and bad, these rules should guide your investing decisions. When your broker wants to discuss the direction of the markets or which stocks or funds are likely to outperform, put an end to the conversation by saying, “I just want to focus on costs, including taxes.”

It will be a short conversation.

Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth advisor with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His next book, “The Smartest Sales Book You’ll Ever Read,” will be published March 3, 2014.