You’re headed to a picnic and need some ice for the cooler. At the store you see two equal-sized bags of cubes, but they are priced differently. You buy the cheaper one, right? Ice is ice.
Well, the same can be said of stock index funds. Those designed to mimic a certain benchmark, like the S&P 500, are all pretty much alike. Yet they are priced differently—and people routinely choose the ones that cost the most, according to a study that the TIAA-CREF Institute has singled out as exceptional work in the field of lifelong financial security.
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Why don’t individuals treat stock index funds like a bag of ice and choose the least expensive one? Answer: Most simply don’t understand how to figure it out. But with a little financial education they may easily overcome what in the long run can be a costly mistake, according to the paper “Why Does the Law of One Price Fail?“ by Brigitte C. Madrian and David I. Laibson of Harvard and James J. Choi of Yale.
Researchers asked individuals to allocate $10,000 choosing from four actual S&P 500 index funds that had been in existence for different lengths of time and had different expense ratios. Almost no one focused on annual fund costs, which for an S&P 500 index fund may range from as little as 0.18% of assets to 2% of assets or more. In the survey, subjects almost all chose funds that charged more than 1% of assets.
Investors collectively spend more than $200 million a year in excess fund fees on S&P 500 index funds alone, the study found. They get nothing for that money, which could be compounding in their accounts instead. Think about it. If you have $100,000 in an index fund that charges 1.2%, your annual cost is $1,200. But you could chop that cost to $200 with a like fund that charges just 0.2%.
Is that a big deal? Well, yes. You’d save $1,000 a year, which if reinvested in the fund, which compounds quarterly and has average annual gains of 8%, translates into an additional $124,000 over 30 years (and a total of nearly $1.3 million)—just because you understood to focus on the expense ratio.
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In the study, almost everyone focused on historical returns. That’s not a bad starting point, especially when comparing actively managed funds. But the only comparisons that matter are those looking at the same periods, like the last 10 years, five years or year to date. In the study, most looked at returns since fund inception, and because the funds had launched at different times these were meaningless figures that often led investors to the funds with the highest fees.
The researchers argue for a greater effort at financial education (at work, in the community and in schools), saying that those who had some training invested in lower cost funds. The authors concluded that those without any financial education generally recognized they may be choosing wrong. But as the authors conclude: “Regrettably, having a sense that your choice is wrong does not necessarily tell you how to fix it.”
