The cost to invest in mutual funds is often couched in terms of expense ratios and commissions. These are important structural costs and certainly worthy of your consideration. However, other costs are not so obvious that can eat deep into your investment return. It’s wise to know what those costs are and how they relate to each other.
Two large costs that are not as obvious as expenses, and often difficult to quantify, are behavioral and tax costs. Behavioral cost occurs when an investor turns over his or her portfolio more frequently than they should and tax cost occurs from fund distributions and share sales in taxable accounts.
Interestingly, the structural cost, behavioral cost and tax cost in a portfolio are often interrelated. If an investor is paying high fees, he or she is usually turning their portfolio over more than a low-fee investor and thereby incurring a greater behavioral cost as well as paying more to taxes relative to their gains. Understanding these costs and how they are related will help an investor earn their fair share of the market’s return.
The Cost Triangle:
Figure 1 illustrates how the three costs; structural, behavioral and taxes, combine together to create the total costs we all face. I believe the best investors learn to minimize these costs, but I don’t believe anyone is immune to any of them.