Ramsey's investment advice is a bit more controversial. Instead of low cost index funds, Ramsey suggests his listeners hire one of his Dave Ramsey-approved Endorsed Local Providers (ELP) who will then sell them a mutual fund with a front-end load. Adding to the controversy, Ramsey suggests a 5% load is a good deal for his listeners. Even the Investment Company Institute (the lobbying arm of the financial services industry) admits a 5% load is near the maximum charge. The average mutual fund with a front-end load only collects about 1% from investors. Endorsed Local Providers pay Dave Ramsey a fee for the business he refers to them.
Many investors don't realize that a small increase in fees and expenses can mean that a large portion of your net worth is being siphoned off by your financial advisor (i.e., the ELP) and the mutual funds he or she recommends. Even a 1/4 percent annual fee is a lot of money over a 30 or 40 year investing lifetime, and 1% is HUGE.
Retire Early's Interactive Dave Ramsey ELP Shaft Detector allows you to visually see how much of your money your Endorsed Local Provider is taking over time, and compares it to the lowest-cost investment available as a benchmark. Users are often surprised to find that the plan their ELP prepared for them is doing more to fund his or her retirement than their own. For example, the spreadsheet below shows the results for a client paying a 5% load to an Endorsed Local Provider recommending funds with the expense ratio and trading costs of the average mutual find (2.09% per year.) The benchmark is a mix of low-cost index funds (VTHRX) with a total expense ratio and trading costs of 0.20% per annum. The Shaft Detector assumes that the ELP and mutual fund manager invests the excess fees they take from the client in the benchmark portfolio and calculates the value of their portfolio over time (the red bubble on the chart below.) It's not uncommon for people's heads to explode when they see the results.
You can change the figures in blue (i.e., Starting Balance, Annual Contribution, Investment Return, Annual Fees and Trading Costs, and Front-End Load) to run your own numbers.
Investment Fees & Expenses
In addition to the Front-End Load that Dave Ramsey favors, there are a whole host of other expenses and costs that financial advisors or mutual fund managers subract from your account. Most investors are familiar with a mutual fund's expense ratio which covers the management and operation of the fund. But they may not realize that the expense ratio doesn't include brokerage commissions that the fund manager incurs on his or her trades, nor the implicit trading costs (e.g., the bid/asked spread, and the market impact costs of acquiring or disposing of a large position in a stock over a short period of time.) These costs may dwarf the expense ratio for a more actively-traded fund.
Money market funds and short-term bond funds typically buy securities directly from the issuer and hold them to maturity. Thus, they don't incur any of the brokerage fees and trading costs that one finds in the secondary market. For stock funds, most of the securities in the portfolio are purchased in the secondary market, so it's important to find a fund with low turnover to keep these trading costs at a minimum. The table below illustrates the implicit trading costs for stocks of various market capitalization.
The Investment Company Institute reported that for 2011 the average US equity mutual fund had an annual expense raio of 1.44% while the top 10% most expense funds had expense ratios of 2.20% or more. The average bond fund had an expense ratio of 1.02% with the top 10% at 1.69% or more. The table below shows the combined affect of both expense ratio and trading costs for several mutual funds.
Fortunately, for the simple two-asset allocation found in most of the academic studies, you can buy low-cost index funds at minimal cost. The table below shows the full cost (i.e., expense ratio, brokerage commission and bid/asked spread) for a portfolio consisting of an S&P500 index fund and a short-term bond fund.
Like most financial advisers, Dave Ramsey argues his listeners should diversify beyond the domestic large capitalization stocks of the S&P 500 to include Growth, Growth & Income, Aggressive Growth, and International stocks. You can include all these categories by replacing the S&P 500 fund with two Total Stock Market funds at little additional cost. Indeed, Vanguard (and other large mutual fund companies) offer one fund solutions that also take care of rebalancing your allocation. Here's an example for someone about 20 years from their retirement date.
How much of my money should a Dave Ramsey-approved Endorsed Local Provider (ELP) take?
The short answer is as little as possible. Even the very low 0.20% annual fees and cost of the Benchmark Portfolio compounded to 6.3% of the portfolio value over 40 years. At a 5% load and 2.09% annual expense ratio and trading costs, the ELP in our example captured an additional 45% of the client's portfolio value, above and beyond the 6.3% take for the Benchmark. As Dave often points out, a committed Christian should strive to tithe 10% to his church. You probably shouldn't let your Dave Ramsey-approved Endorsed Local Provider take any more than that.
One of the few guarantees in investing are the fees and commissions your ELP and mutual fund manager deduct from your account. They make money even if you don't. The stock market goes up and down, but the money you lose to fees and costs is gone forever.
Resources for more information
The Hidden Costs of Trading -- NYU Stern School of Business
Evaluation of the biases in execution cost estimation using trade and quote data Peterson, M., and Sirri, E.
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Copyright © 2012 John P. Greaney, All rights reserved.