By JACK HOUGH
U.S. stocks have offered minimal returns over the past five years, and bond yields are near historic lows.
At least investors have one thing to cheer about: Thanks to a price war among mutual-fund firms, creating a low-cost portfolio has never been easier.
The average stock mutual-fund investor paid 0.79% in fees last year, according to the Investment Company Institute, a fund-industry trade group. On a $100,000 portfolio that earns 5% a year, an investor who cuts that fee to 0.1% can hang on to an extra $10,700 over a decade.
Bond investors have plenty of incentive to cut costs, too. The average bond fund paid 0.62% in fees last year. That is enough to gobble nearly one-third of the recent 1.94% yield on the Barclays Capital U.S. Aggregate Bond Index.
To some investors who already are frugal -- paying, say, 0.25% a year in expenses -- the potential savings from cutting that figure might seem negligible. They could be falling prey to a consumer trap labeled "relative thinking" in a study published last year in the academic journal American Behavioral Scientist.
While many shoppers say they would drive across town to save $20 on a jacket, the study says, few say they would budge to save that much on a car. The dollars are the same relative to the effort, but shoppers tend to compare savings with purchase amounts.
On that $100,000 portfolio earning 5% a year, each 0.1% in fees is worth about $1,600 in lost returns over a decade. Investors who would jump at the chance to save that much on their next television set should consider doing likewise with their portfolios, so long as they can do so without sacrificing performance.
The chances are good that they can. Last year, 84% of U.S. actively managed stock funds failed to beat their benchmarks, according to Standard & Poor's. As studies have long shown, most mutual-fund investors are best off sticking with cheaper passive index funds or exchange-traded funds.
Here's how to do that while keeping fees lower than ever.
Decide on an appropriate "asset allocation," or how to divide your funds among different asset classes. That isn't as complicated as it sounds. The American Association of Individual Investors, a nonprofit membership group, shows how to decide among aggressive, moderate and conservative allocations, and offers model portfolios for each. The information is free at www.aaii.com/asset-allocation.
Select cheap index funds for each asset class. Pay particular attention to the costs on broad U.S. stock funds, which are the largest holding for many index investors.
Two years ago Charles Schwab (SCHW)
Investors will pay more for some other categories of funds, but intrepid shoppers can find good deals on those, too. The Vanguard Total Bond Market (BND)
Rebalance your portfolio when one slice of the asset-allocation pie grows too large or small. If you want 60% in stock funds and you end up with 62%, don't rush to make changes. The percentages are loose guidelines. But if you get to 65% or 70%, move any continuing contributions to underweighted funds -- or do some selling.
Of course, some fund investors might feel skilled enough to tell which fund managers will outperform the rest in coming years, and so may be willing to pay higher fees for active management. Then again, picking good stocks is arguably no more complicated than picking good mutual funds, and investors who pick their own stocks get the lowest fees of all.
For example, at Scottrade, which AAII surveys show is the most popular choice among its members, stock trades cost $7. An investor who buys a dozen stocks and replaces two each year will make 48 trades over a decade, costing $336. On a $100,000 portfolio, that is an expense ratio of about 0.03% a year.
Individual bonds pose more of a challenge. Fees are built into bonds by dealers who match buyers and sellers, and they often charge dearly for small trades. So while an investor who is spending $100,000 on a single issue may be able to negotiate down to a one-time fee of 0.25%, one who is spending $10,000 can easily pay a full percentage point.
There is an exception: U.S. Treasurys are free to buy and hold, even in smaller lots, through the federal TreasuryDirect program. Individual Treasurys offer the peace of mind of a maturity date with a government guarantee. The yields certainly won't impress at the moment. But then, neither will those of most bond funds.—Jack Hough is a columnist at SmartMoney.com. Email: firstname.lastname@example.org