The Tyranny Of Long-Term Compounding Costs


Only 1% of traders are able to beat the market after expenses. Granted, this is your average overconfident Joe, buying and selling stocks on a whim. One would expect mutual fund managers, those smart, suit-clad, Ivy League graduates, people whose job solely consists of studying the market, to do much better. Except they don’t. Fewer than 1% of mutual fund managers consistently beat the market.

Our inborn overconfidence and massive blinders are why I use index funds. I could spend hours every month fooling myself into thinking that I know more than the millions of other people out there doing the same. Instead, I spend only 10 minutes every month “investing” — roughly the time it takes to log into Vanguard and buy shares in VTSAX.

This frees up time to do things I actually enjoy doing and prevents me from throwing my money away.

The idea driving index funds is that since no one can beat the market, the key is to keep costs low. Accordingly, an important number to look at is a fund’s expense ratio, which is the fee the company offering the fund charges for upkeep. For example, if you have $1,000 invested in a fund that charges a 1% expense ratio, then $10 every year come out of your pocket. Those bloated CEO salaries have to come from somewhere.

Don’t let the miracle of long-term compounding of returns be overwhelmed by the tyranny of long-term compounding of costs.
— Jack Bogle

It’s easy to ignore the effect of expense ratios. 2.5%, a typical expense ratio, seems like a minuscule number. Yet the danger, as pointed out by Bogle, is in their compounding nature.

I thought I’d take a look at how expense ratios would affect one’s investment over 20 years. The chart below assumes you invest $3,000 in the mutual fund every year and the market returns 7% every year and shows the effect of expense ratios ranging from 0.04% (the expense ratio in VTSAX, the fund I use) to 2.5%.

With an expense ratio of .04%, you’d lose almost $536 of your investment, a .44% loss, after 20 years. Not too bad. However, as we slowly make our way from left to right, the sights get scarier and scarier. With an expense ratio of 1%, we are giving up $12,629, a 10.27% loss, and at 2.5%, we are giving up almost $30,000! The horror.

The more positive note hiding in this chart alongside the “tyranny of long-term compounding of costs” is the “miracle of long-term compounding of returns”. If you invest $3,000 annually over 20 years assuming a 7% return (the real — after inflation — rate of return from 1950–2009) and low expense ratio, you’d end up with over $120,000, doubling your investment.

So if you want to spend as little time as possible investing look into index funds with low expense ratios. And with Halloween coming up, if you want to be something really scary consider dressing up as a High Expense Ratio.


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