Lesson 6 of 7
The index fund baseline
A low-cost index fund is the bar every stock picker has to clear, once fees, time and taxes are all counted.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A low-cost index fund is the bar picking your own stocks has to clear, after fees, time and taxes.
- A fee is charged on the whole balance every year, so it compounds against you the way a return compounds for you.
- Buffett has pointed most investors, and the cash his will leaves in trust for his wife, at a very low-cost S&P 500 index fund.
Before picking a single stock, it is worth knowing what doing nothing costs, and what doing nothing already achieves. A cheap index fund is the standard any more active choice has to beat, after its own costs are counted too.
What a fee costs over 30 years, on $10,000 at 7% a year
- 0.05% annual fee · net rate 6.95%$75,063
- 0.50% annual fee · net rate 6.50%$66,144
- 1.00% annual fee · net rate 6.00%$57,435
- 2.00% annual fee · net rate 5.00%$43,219
A fee compounds too
A fee is not charged once. It is charged on the whole balance every year, which means it compounds against you the same way a return compounds for you. On the same $10,000 and the same 7 percent gross return, a fund charging 0.05 percent a year grows to $75,063 over thirty years. One charging 2.00 percent, a gap of under two percentage points, grows to only $43,219.
What the fee is actually called
A fund's yearly cost is its expense ratio: a share of the assets, taken out automatically rather than billed. It sits in the fee table near the front of the fund's prospectus. Two funds on the same index can charge different ratios, so compare the ratio, not the index name.
What Buffett's will says
Buffett argued in his 1996 letter that, for most investors, an index fund with minimal fees is the best way to own stocks, and that after fees it beats most professionals. In 2013 he wrote that his will sends cash to a trustee for his wife, with the advice to hold 10 percent in short-term government bonds and 90 percent in a very low-cost S&P 500 index fund. His Berkshire shares go to charity.
Why most fall short
Together, investors own the whole market, so before costs the average dollar invested earns the market's return. After costs it must earn less, and a low-cost index fund keeps those costs small. Buffett made the point with farms in 2013: owners trading farms with each other grow no extra crops, and pay for the trading.
Check yourself
Why does even a small annual fee matter a great deal over thirty years?
- It is charged once, at the start
- It is charged every year on the whole balance, and compounds against you
- It only applies to the gains, never the original amount
Show the answer
Answer: B.
A fee taken every year from the whole balance shrinks the base a return compounds on, in every later year as well as this one.In his 1996 letter, what did Buffett say most investors would do best owning?
- A basket of individual growth stocks
- A low-cost index fund
- Long-term government bonds only
Show the answer
Answer: B.
He wrote that most investors, institutional and individual, would do best through an index fund charging minimal fees.Over 30 years at 7 percent, how much more does $10,000 end with at a 0.05 percent fee than at a 2.00 percent fee?
- $5,850
- $31,844
- $43,219
Show the answer
Answer: B.
$75,063 minus $43,219 is $31,844. A flat 1.95 percent of $10,000 for 30 years would be only $5,850; compounding makes the gap more than five times larger.Sources
- Berkshire Hathaway shareholder letter, 1996, on a low-cost index fund for most investors.
- Berkshire Hathaway shareholder letter, 2013, on the instruction to the trustee for his wife's bequest, 10 percent short-term government bonds and 90 percent a very low-cost S&P 500 index fund, and on frictional costs, using farmland.
- Bogle, The Little Book of Common Sense Investing, 2007, on costs compounding against an investor over time.
What this leaves out
- The fee comparison is illustrative. A real fund, a real rate of return and a real time horizon will not match these four numbers.
- A management fee is one cost among several. Trading costs and taxes are not modeled here.
- Past index returns are not a forecast of future ones.
- Nothing here is advice about any security, and it does not compare any named fund or manager.