Understanding the importance of investment costs requires understanding the difference between a percentage point and the percent that something is to a whole. My wonderful wife Alice and I learned this lesson in an unforgettable way recently when dealing with something far more important than investing.
In July Alice was diagnosed with breast cancer. It has been a difficult time for us but her prognosis looks good and we have every hope that she will make a complete recovery. In August she had surgery, which went well. The tumor hadn’t spread and the doctor is confident she got all the cancer.
Several weeks after surgery we met with an Oncologist to discuss whether to do chemo therapy or not. The oncologist informed us that with the type of cancer Alice had, and the size of the tumor, there is a 10% chance of cancer returning within ten years if she doesn’t do chemo, and a 5% chance if she does.
Chemo is no fun (Alice would call this the understatement of the year) so you don’t want to do it unless the benefits are clear. The doctor told us he recommended chemo but left the decision up to us. What would you do?
On first glance it appears that doing chemo would only reduce the chance of cancer returning by 5% (from 10% to 5%) but is that really true? If so, it probably wouldn’t be worth it.
A closer look reveals that chemo would actually reduce the chance of cancer returning by 50% (5% / 10% = 50%). The first calculation tells you how many percentage points you are reducing your risk by. This is important information, but not sufficient to make a decision. The second calculation tells you how much benefit chemo will provide, which is what you really need to know.
Once we understood clearly the difference between percentage points and percent the decision was easy. A 5% reduction in risk might not be worth the pain and suffering of chemo but a 50% reduction certainly is.
Alice, with my full support, chose to do the chemo. Her first treatment was about ten days ago and she is learning first-hand how difficult chemo is. The only thing that makes it bearable is the knowledge that she is reducing the risk of having to confront cancer again by half.
A clear understanding of the difference between percentage points and the percent something is of a whole is vital to making certain types of decisions.
As explained in part II, mutual fund companies report expense ratios based on total assets under management. This allows them to report expense ratios that seem almost insignificant. But are they really insignificant? Thinking of your investment costs not as a percentage of the amount in your account, but as a percentage of your after-inflation gains for the year, will probably change your perspective.
For the past 100 years stocks in the US have averaged about a 9% annual gain. Assume you are invested in a fund with a 1% expense ratio, it was an average year for stocks, and your fund’s performance matched the market before expenses. In this example the mutual fund company would report to you an 8% gain (9% total gain less the 1% they keep).
Are you really only paying 1% in expenses? Of course not. You are paying 1 percentage point, but your actual expenses are 11% of your gain (1% / 9% = 11%).
Inflation has averaged about 3% per year over the last 100 years. Assuming that it was also an average year for inflation your real return for the year (the difference in spending power represented by your gain) was only 6% before expenses (9% gain less 3% inflation). In this case your 1% percentage point expense ratio would take almost 17% percent of your real gain for the year (1% / 6% = 17%). All of the sudden that 1% expense ratio doesn’t seem so insignificant.
In years when stocks perform well the percentage you pay of your gain goes down, but in years stocks perform poorly investment costs can take most or all of your gain. In fact, even if you lose money during the year you will still pay 1% of the average amount in your account. As financial author Jonathon Clements reminds us, “Performance comes and goes. Expenses are forever.”
Understanding the difference between percentage points and percent made our decision about chemo therapy much easier. It can also help you make wise investment decisions. When you understand how much investment costs are really costing you taking steps to reduce them becomes an obvious choice.
Figure out what percent of your real investment gain you paid last year in costs by:
- Taking the reported gain from each fund
- Adding the expense ratio of each fund to get the gain before costs
- Subtracting the 2013 inflation rate of 1.5% to get your real gain
- Dividing the expense ratio by the real gain before costs
If you are a woman over 40 make an appointment to get a mammogram. If you are a man, talk to the women in your life about doing this. Alice’s mammogram in June almost certainly saved her life. It really could be a matter of life and death, so don’t delay.