I grew up before computers, video games, the internet, i-Pods, i-Tunes, i-Phones, i-Pads, Facebook, and Twitter. Back then people had to entertain themselves and one way this was done was through sing-a-longs. When I was a kid many community and church gatherings had sing-a-longs and one song that was often sung was a silly old folk song called, There’s a Hole in My Bucket. The first two verses go like this:
There’s a hole in my bucket, dear Liza, dear Liza. There’s a hole in my bucket, dear Liza, a hole!
Then mend it, dear Henry, dear Henry, dear Henry. Then mend it, dear Henry, dear Henry, mend it!
The song goes on for many more verses, which I will spare you, and they never do get the bucket mended. In the end they need water to mend the bucket, but they can’t get any water because… there’s a hole in their bucket.
Yes, it is as annoying and pointless as it sounds, but people really used to enjoy this kind of thing. Just be grateful I can’t convey the tune to you in writing or you would have this song stuck in your head for the next several days, as I surely will.
Henry and Liza don’t come across as being the sharpest tools in the shed but maybe I haven’t been giving them enough credit. After all, there are many ways to judge a bucket. You can look at its size, shape, cleanliness, the material it is made out of, its aesthetics, and whether or not it has a comfortable handle. All of these attributes are important in certain circumstances but Henry and Liza quickly realized that the most important characteristic of a bucket is whether or not it will hold water. They were smart enough to realize that it is pointless to continue trying to use a bucket with a hole in it. They understood that if your bucket leaks your first priority should be to mend it.
I mentioned earlier that the song was pointless, but maybe it isn’t. After all, Henry and Liza taught us the best way to predict the future performance of buckets. A bucket without a hole, or with a very small hole, will perform better than a bucket with a large hole. Although they didn’t have the skills or tools needed to fix their bucket they at least correctly identified the problem.
Predicting Future Mutual Fund Performance
Morningstar is a company that performs research on mutual funds and sells the results. Their entire business model is based on understanding mutual funds better than anyone else. Morningstar knows mutual funds.
Everyone wants to know what the future holds so Morningstar has put a lot of effort in trying to determine how to predict which mutual funds will do well in the future. In one study Morningstar looked at several different attributes of mutual funds to determine which ones could best predict future performance. The attributes they studied included past performance, expenses, turnover, manager tenure, net sales, asset size, alpha, beta, standard deviation, and the Sharpe ratio. The study’s conclusion was, “The expense ratio is the only reliable predictor of future mutual fund performance.”
Russel Kinnel, Director of Mutual Fund Research at Morningstar, further explained the value of costs in selecting mutual funds:
“If there is anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make better decisions. In every single time period and data point tested, low-cost funds beat high-cost funds….Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance.”
The results of the Morningstar study should not have been surprising. After all, mutual funds are really nothing more than buckets that hold investments, and, as Henry and Liza taught us long ago, the best predictor of the future performance of a bucket is whether or not it will hold water. A big expense ratio is like a large hole in the bottom of your investment bucket and mending the hole is the best way to improve the bucket’s performance.
- A bucket without a hole, or with a very small hole, will perform better than a bucket with a large hole.
- The best way to improve your investment performance is to mend the hole in your investment bucket.
Vanguard founder John Bogle states, “Great rewards grow from small differences in costs.” How great are the rewards available from mending your investment bucket?
Suppose you invest $500 per month for 30 years in a mutual fund that earns 9% per year before expenses. Further suppose the mutual fund has a 1% expense ratio, so your actual return is 8% per year. At the end of the 30 years you will have $745,180 in your account.
What if you could mend that hole in your bucket and prevent 1% of the money from leaking out every year? In that case you would get the entire 9% annual return. After 30 years you would have $915,372 in your account, which is an increase of more than $170,000 just from mending your bucket.
Of course, it might not be possible to completely patch the hole, but you can come close. Vanguard has many mutual funds with expense ratios of less than 0.10% and I only pay 0.05% on the Schwab ETFs I invest in. Either of these options would reduce a damaging leak to a slow drip. In addition, some actively managed funds have expense ratios of well over 1%, so, depending on what you are investing in now, you might very well be able to reduce your costs by a full 1% or more.
Henry and Liza correctly identified the problem posed by their leaky bucket but didn’t have the tools or know-how to fix it. Fortunately, both the tools and know-how are available to you. To fix your leaky investment bucket do the following:
- Review the investments in your 401(k) and determine what you are paying in expenses and if lower cost alternatives are available to you. The lowest cost options will probably be index funds, which have traditionally performed very well. If you are not currently investing in low-cost index funds make the move now.
- Some employer plans don’t have low-cost alternatives. If your 401(k) plan doesn’t have choices available to you with expense ratios of less than 0.50% only invest enough money in the plan get the employer match.
- After getting the employer match open up a Vanguard or Schwab IRA and invest up to the maximum allowable each year ($5,500 per person for 2014) in the low cost options available.
These steps should substantially reduce the leak in the bottom of your investment bucket and improve your future investment performance. Henry and Liza would be proud.