Investing

How To Beat The Expense Ratio

How To Beat The Expense Ratio

In the personal finance community, people tend to focus all of their energy on the minutia and forget what actually matters. They get sucked into the rabbit hole of “Which fund is best?” or “How can I reduce my expense ratio by .01%?” However, none of these small details make a dent compared to how much money you contribute.

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The Two Ways to Increase Your Contributions

There are two main ways to increase your investment contributions:

  1. Spend less
  2. Earn more

Let’s start by focusing on method #1.

Spend Less

On an absolute dollar basis, reducing your spending is the best way to hold on to more money. What I mean by “absolute dollar” is the actual amount of money you save in your wallet, bank account, or [insert other dollar-holding vehicle].

If I was an average American household earning $59,055 per year and I earned an additional $100, I would only pocket $78 in absolute dollars. Why? Taxes. At $59,055 in annual income, I am in the 22% marginal tax bracket … meaning that I only get to take home 78% of my earnings!

Note: I am ignoring state tax, Medicare, and social security contributions for simplicity.

However, if I were to instead spend $100 less dollars, I would realize 100% of those savings! That is because the money in my wallet/account has already been taxed.

Clearly, spending less is more efficient than earning more because taxes are eliminated from the picture. However, there is only so much you can save. At some point, you’ll be living under a bridge and eating scraps from dumpsters. Nobody wants that type of life … so that’s where earning more comes into play!

Earn More

After you’ve minimized your spending to reflect the type of lifestyle you want to live (hopefully not bridge living and dumpster diving), the next move is to increase your income.  The one enormous benefit that earning more has over spending less is that your earnings potential is unlimited.

On the income front, there’s no one stopping you. You could earn an additional $5 per month by filling out online surveys or $100,000 per month by building a successful business.

Or by trying some of these!

There are literally thousands of ways to earn some extra income each month. You just have to be willing to put in the effort!

The savings equation is quite simple: [What You Earn] – [What You Spend] = Savings.

Optimize both pieces of this equation and you will set yourself up for a blindingly bright financial future.

Unraveling the Expense Ratio

As mentioned before, increasing your investment contributions has a much greater impact than optimizing your expense ratios. But how much of an impact do expense ratios actually make? The best way to show you is through examples. Let’s take a look at three different scenarios.

Before we begin, let me outline my assumptions for these scenarios.

  • Investment Horizon: 40 years – Each individual will invest over a span of 40 years.
  • Addition Annual Contribution: $1,200 – In their secondary scenario, all of the individuals earn an additional $100 per month (post-tax). This translates to $1,200 in additional investment contributions per year.
  • Annual Growth Rate: 5% – The invested money will grow at an average rate of 5% annually.
  • Each scenario will consist of a comparison between the individual’s “Regular” investment vs. their “Additional” investment.
  • Each individual starts with $1,000 in his/her investment account.

Least Wealth Linda

Regular-investment Linda contributes $1,000 to her investment accounts each year.

Additional-investment Linda contributes $1,000 plus $1,200 ($100 per month) to her investment accounts each year for a total contribution of $2,200.

I was actually really surprised by this result when I ran the scenario. Additional-investment Linda can absorb a 3.25% expense ratio and still make out the same as Regular-investment Linda over the 40-year time horizon! Those additional annual contributions of $1,200 really went a long way.

Middle Wealth Mike

Regular-investment Mike contributes $10,000 to his investment accounts each year.

Additional-investment Mike contributes $10,000 plus $1,200 ($100 per month) to his investment accounts each year for a total contribution of $11,200.

Additional-investment Mike can absorb a 0.46% expense ratio and still match the returns of Regular-investment Mike over the 40-year time horizon!

Tons of Wealth Tori

Regular-investment Tori contributes $100,000 to her investment accounts each year.

Additional-investment Tori contributes $100,000 plus $1,200 ($100 per month) to her investment accounts each year for a total contribution of $101,200.

Even while contributing $100,000 annually, Additional-investment Tori can withstand a 0.05% expense ratio and keep pace with Regular-investment Tori over the 40-year investment horizon.

So, Should You Care About Expense Ratios?

The simple answer is “Yes”. If you are paying  a 2.00% expense ratio on some actively managed mutual fund, my advice is to get out as soon as possible and switch to a lower-cost fund from Vanguard.

The point of this analysis was certainly not to suggest that expense ratios aren’t important. Rather, I aimed to highlight the power of additional contributions and illustrate that ‘amount invested’ matters far more than your fund’s expense ratio.

You can certainly optimize on both the contribution and expense ratio fronts, but I wouldn’t waste too much energy on expense ratios unless they are ridiculous (higher than 1%).

Even Tons of Wealth Tori, who contributed $100,000 per year to her investment account and accumulated $12,000,000 over her 40 years of investing, could offset a 0.05% expense ratio just by contributing an extra $1,200 per year!

The bottom line is, focus on increasing your contributions. No matter who you are, no matter what your current situation is, I can almost guarantee you have the ability to earn an extra $100 (or waaay more) each month.

Let go of your limiting beliefs, increase your income, and accelerate your financial freedom!


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9 thoughts on “How To Beat The Expense Ratio

  1. Fees suck. And while someone can make up the difference by investing more (always recommended!) that person is still getting nailed with fees on the additional investment amount.

    I did a bit of an example on this on Part 2 of my How to Manage Your Money Without Being Overwhelmed and the difference between my 0.08% (current) and hypothetical 1.08% was losing 35% of my earnings and 3 years of retirement… ugh.

    I know I’m preaching to choir here! But goodness I never knew how much of a dent actively managed funds and advisers can be!

    1. Definitely, Cooper. There are certainly two sides to every coin.

      On one side, there are those who know very little about finance and are getting clobbered with 2.00% expense ratios on their funds. Those people should certainly spend some time looking into alternatives such as Vanguard and Schwab.

      On the other side, there are the hardcore FI people who fight for every basis point they can possibly get. While it’s important to reduce your expense ratios, I don’t think it’s worth switching from say Vanguard (.04% expense ratio) to Fidelity just because they have a new fund with a 0% expense ratio. It’s probably easier and more fun to think of a creative way to contribute an extra $100 per month.

      Thanks for stopping by, as always!

    1. Thanks TJ! I know you’re 100% with me on this one. Increasing income is SO important, but unfortunately often overlooked in the FI community. Can’t wait to spread this message even more on the podcast.

  2. The expense ratio is a deceptive and imho almost criminal way that brokers can siphon off wealth. It’s easy to to think of 1% of of assets as not being terribly significant. But these fees are devastating long term.

    Here’s the way I view it: Current asset value is merely a fluctuating opinion. But dividend distributions are real money. And earnings are the reason stocks have value in the first place. If your investment has a 2% annual dividend distribution but you’re handing over 1% to your broker in the form of an expense ratio, you’re essentially handing over 50% of your dividend income to them. That’s quite a “tax” to pay on your dividend income.

    1. I really like the way you framed that, Rob! There’s absolutely no way that your advisor/fund manager deserves 50% of your profits.

      Unfortunately, a lot of people don’t even know what an expense ratio is… that’s why I have this blog in the first place!

      Thanks again for stopping by.

  3. Sound advice. I would add a third rule, after 1) Spend less, and 2) Earn more: 3) Don’t destroy what you have achieved! I’ve seen so many friends doing great on 1 and 2, and then make one of those ‘new worth destroying’ mistakes such as buying a new car!

    By the way, I have renegotiated my expenses with my broker several times in the past few years, and now they are 1/3rd of what they were at the beginning. So, sometimes this can help quite a bit with the ‘spend less’ rule 🙂

    1. I love that third rule! Hopefully those reading this blog understand how to manage their finances and make sure not to destroy what they’ve built.

      And wow, that’s amazing! How did you initiate that conversation?

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