Why Become a Frugal Investor?

Stocks are volatile and future price movements are uncertain. The only certainty known to the investor is how much of their investment savings will get siphoned and lost through expenses, fees, commissions and taxes on dividends and capital gains. Minimizing investment expenses is the only free lunch for the investor.

Since stocks are so unpredictible, the frugal investor knows that minimizing costs is the most important factor to achieving long term investment gains. This is even more important than trying to pick the right stock. Academic research theorizes that markets behave efficiently and that the market is priced to account for all information. This academic belief is called Efficient Market Theory. The theory assumes that if markets are honest without insider trading etc. then one cannot outperform the market based on superior stock picking skills. If one cannot beat the market through stock picking and trading skills then the best way to increase long term market returns is assume gains similar to the market while minimizing costs. John Bogle applied this theory and started the low cost Vanguard Funds. We believe that maximizing long term investment gains is attained through minimizing costs and choosing the right stocks to hold for the long term.

The historical data seems to support the academic point of view of efficient markets. Most mutual funds on average don't even beat the market. In fact, the average mutual fund returns less than 2% per year compared with stock market returns. The reason for the underperformance is that the fund expenses eat into returns.

Source of the graph, John Bogle, P.119 Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor

The chart on the left shows the percent of mutual funds that have not met the returns of the S&P 500 during each year underperforming the market. The reasons for underperformance are the fees and expenses of mutual funds. The average portfolio manager is paid $400,000 a year for not even beating the market. Does the average portfolio manager deserve to get paid that much?

Assuming that the average investor will underperform the market by an average of 2% a year can add up to significant amounts. The chart below shows the difference of the market average and mutual fund with $10,000 invested at the end of 30 years is nearly $75,000.;

At the end of 30 years the hypothetical return for an investor who invested in the market average would have 73% more money in retirement money compared with the investor who invested in mutual funds. The chart shows that the difference of the market average and mutual fund at the end of 30 years is nearly $75,000. At the end of 30 years the hypothetical return for an investor who invested in the market average would have 73% more money in retirement money compared with the investor who invested in mutual funds. Over the long run funds with higher fees will likely return lower results.  There is a way to set up your own portfolio and avoid many of the fees.  For more information on how to do this, see guideline to frugal investing.

The graph shows shocking revelations about holding mutual funds in a taxable account.  The returns of $10,000 invested over 30 years in a typical mutual fund would grow to a meager $40,000 over a 30 year period.  Assuming the tax expense of a 30% tax bracket,  a 2% mutual fund expense, and a 10% yearly capital gains distribution, the annual return of a mutual fund would be 5% per year.   The last year shows estimated declines due to long term capital gains owed because all securities will be sold at this time and taxes must be paid.  Assume  that the long term capital gains rate remains at 15% after 30 years. In summary, If you want to hold mutual funds at least hold them in a non taxable account.  For more information on non-taxable accounts see guideline to frugal investing