Understanding How Mutual Fund Fees are Structured

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Those of you who are looking to get started in the stock market may have no idea where to start when it comes to picking stocks. You may know that the general rule of thumb is to diversify. That’s what everyone means when they suggest not to put all your eggs in one basket. The reasoning is to limit the amount of exposure to any one stock. But how do you go about it?

You may wonder how you could diversify when you only have a limited amount of funds. You might have heard of the term mutual funds, which is one of the most popular forms of diverse investing. However, before you invest in any mutual fund, you need to understand how they work and be aware of the fees associated. Here, I will go over what to look for.

A mutual fund is where investors pool their money together which is then managed by professionals to try and earn capital gains on their investments. Picking which one to invest your money depends on whether you share similar philosophies and the type of investing strategy they implement. Before investing in mutual funds, you need to make sure you are knowledgeable about them so that you can make educated decisions and not be surprised by any costs. Quite honestly, that applies to pretty much everything. After all, knowledge is power. Below, I’ll talk about the costs associated with mutual fund investments.

EXPENSE RATIO

Since there are people managing and running the fund, there are operating expenses. Investors are charged an expense ratio. Simply put, it’s just the ratio of the fund’s total operating expenses to its total assets. If you invest $10,000 in a mutual fund with a 1% expense ratio, you pay $100 to cover the fund’s operating expenses. Oftentimes, the expense ratio correlates with the level of trading activity of the managers. If it is an actively managed fund, then it’ll require more time and research from managers, meaning you’ll have to pay them more.

SALES CHARGE

Some companies include sales charges, or commissions, when you purchase or sell mutual funds. There are the front-end loads, which is the fee that you pay upon purchase of a share. There are also back-end loads, which you pay upon sale of the share. Some mutual funds don’t charge any upfront fees, also known as a “no-load fund.”

There are Class A shares, which normally come with front-end loads. Then there are also Class B and Class C shares, that usually come with back-end loads. Later on, I’ll get into the nitty gritty of specific types of mutual funds, and the best ones for your personal portfolio. Everyone’s financial situation is different, so there will be different kinds of mutual funds that tailor to your strategy.

REDEMPTION FEES

Redemption fees are another fee that you pay if you sell the share after within 90 days. Since mutual funds are created for long term investing, redemption fees are charged to discourage any short-term buying and selling. These are not to be confused with back-end loads. Back-end loads are sales commissions paid to a broker. Redemption fees are paid to the fund to discourage investors from early withdrawal.

MY OPINION

Ideally, you’re paying more in fees and higher expense ratios in hopes that this extra due diligence from the portfolio manager will result in higher returns. Personally, I prefer passively managed funds because of the lower costs. Index funds are an example of passively managed mutual funds. To put it very simply, index funds mimic the stocks inside an index, such as the S&P 500. Historically, most fund managers are unable to consistently beat the market over the long term, so why pay the extra fees associated with actively managed funds, whose primary goal is to outperform the total stock market? The key is buying and holding. Say it with me, “buy and hold.” If you only get one thing out of this article, please understand how important it is to buy and hold. Do not attempt to time the market.

Make sure you do your due diligence to find out the type of fees that are charged to you. They can take a huge bite out of your investment. If you don’t want to have to pay hefty sales charges, you can buy mutual fund shares directly from the company themselves. That way, there is no necessary middleman, such as a broker or financial planner, to pay any type of sales commission to. Don’t just automatically assume that no-load funds are better though. They may have no sales charges, but it could have a higher expense ratio. Just be aware of how the fee structure of the fund works.

These are the main fees associated with investing in mutual funds. Be as knowledgeable as you can about the mutual fund and whether it’s the right one for you. There is still a lot more to know about mutual funds, but let’s take it slow. In the near future, I’ll talk about types of mutual funds, where to buy them, which ones are the best for you depending on your situation and risk tolerance, and if they play a part in my personal portfolio.

My Impulsive Car Purchase

No, I did not actually buy a Porsche 918 Spyder (I wish) in the image above.

I would consider myself a relatively frugal spender. I mean, I still eat out with coworkers once a week. I make monthly car payments that I will admit, I sometimes have regrets about. I live with my parents, but I still pay rent. Add up all my expenses and it’s about 32% of my take home pay. Being 22, recently graduating, and still living with my parents, I still don’t have huge expenses. I don’t have to worry about caring for a child. I don’t have a monthly mortgage payment or any expenses related to maintaining a house. When I bought my car, it was kind of an impulsive decision because I’ve always had an interest in cars and I always dreamed about what car I would buy as soon as I got a job. 

I seriously considered selling it and buying a much cheaper option, but ended up keeping it because I do like my car and enjoy driving it. However, I still don’t like paying so much monthly for it, so I decided to get creative and find other ways to reduce my expenses. I live about 30 miles from my work and factor in rush hour traffic to Downtown Houston and that’s a hefty gas bill. Therefore, I’ve just recently started taking the bus to work and the employer pays for it.  

Not only do I pay a lot less for gas, but my car is not depreciating as quickly and I will not have to take it for repairs as often. Now, I estimate that my expenses will be about 29%. If you think it sounds like a tiny difference, read my article about compound interest to see how profound of a difference a few dollars a month can make. Put that extra money in investments and it’ll build up.

If I ended up selling my car and buying one half the price of my current, I could reduce my expenses to as low as 24% of my take home pay. With my current finances, I don’t think that’s completely necessary. However, if you’re in a sticky financial situation, I’d recommend going as cheap as you possibly can on a car.  

I’m not even done mentioning all the added benefits of this little decision to simply start taking the bus. During my first week taking the bus, I found myself either wasting time on my phone or just looking out the window. This is what ultimately led me to the idea of starting the Future Millionaire’s Blog as a side hustle to help others with their personal finance. I spend at least two hours on the bus a day, and I figured that I should be doing something of value.  

I really want to emphasize that everyone’s financial situation is different. I’m assuming most of you are also on the same journey as me, so I would highly recommend not splurging too much on a brand new car. For most Americans, car purchases are a very serious deterrent to building wealth. The average new car purchase is over $36,000! I can’t give you advice as to what car you should buy, but it is essential that you do not live beyond your means.  

How do I know what is beyond my means? My personal rule of thumb is that my car payment should not be more than 10% of my take home pay. You need to be aware of what your financial situation is. Know where your money is going. If you don’t, then make an excel worksheet or find a free budget app to track your expenses. Then plan your car purchase accordingly. For those of you who only see a car as getting you from Point A to Point B, you could get easily find a cheap, used vehicle under $10k that can still be very durable. 

You don’t have to be like everyone else. While everyone else is buying brand new, forty-thousand dollar cars, you could be putting that money into something that will actually appreciate in value over the long run. Would you rather appear rich to your friends, or actually BE rich? Again, I think my car purchase was rather impulsive, but it wasn’t brand new and it certainly wasn’t over thirty grand. 

How much car you can afford is personal to you. That’s why it’s called “personal” finance. You need to be aware of what YOU can afford. Like I mentioned before, I personally do not want my monthly car payment making up more than 10% of my take home pay. If I really wanted to, I could’ve just gotten a crappy car paid in cash and it’ll still get me from point A to point B. I just don’t feel like that was necessary given my financial situation. I mean, if you’re one of those FIRE (Financial Independence, Retire Early) fanatics, then you’re looking for cars as inexpensive as possible. But that’s a whole ‘nother level of extreme frugality that I’ll talk about later. For now, just assess your financial situation and plan your car purchase accordingly. 

Myths to Becoming Rich

Myth #1: The only way to get rich is being born to a wealthy family.

This is so far from the truth. A Fidelity survey revealed that 86% of millionaires earned their way to millionaire status. They were not necessarily wealthy growing up. Rid yourself of the idea that you need to be born to a wealthy family in order to become a Future Millionaire.

If you read about me, you know that I stress the importance of having the right mindset. Making excuses for yourself will not get you anywhere. The fact is that most millionaires went through some of their own financial hardship at some point in their life.

You may see people in fancy cars or fancy homes and you may feel the temptation to start judging them. What we don’t see is what their path to prosperity entailed. Many develop this narrow-minded perception of those showing off their wealth, but fail to see the bigger picture. 

My theory is that, deep down, we aren’t interested in seeing what their journey looked like. Everyone wants to be rich. When our brain wants something, we think of the easiest and most efficient way to attain it. That’s just how everyone’s mind works. Oftentimes, we don’t want to know the how because there’s a part of us that knows we’re in for a rude awakening.

 I’m not saying any of this to insult anyone. I think this is just a natural phase of the developing mind. Our minds always think of the quickest and easiest way to attain something. The first step to becoming wealthy is getting past this phase and understanding that there is no shortcut. Stay in this phase too long, and a sense of self entitlement may begin to develop, slowly eroding the incentive build wealth.

Myth #2: My frugal habits will be the ultimate driver to my eventual success. 

Technically yes… and no. Simply saving money is not going to be the main wealth driver to your Future Millionaire status. Okay fine, if you’ve got a super high paying job, then maybe you can. But if you’ve already got a high paying job, I assume you’re not here to figure how to get rich (Congrats to you).

For most of you that are here though, just saving money won’t cut it.This is only the first part of it. The second part is putting your money to work. In other words: Invest. Your. Money. If you just save your money into a bank account that earns just a fraction of a percent of interest, you could actually be losing money. This is due to inflation. A dollar today is more valuable than a dollar tomorrow. Invest your money so that your money can grow.

I cannot stress enough how incredibly powerful the concept of compound interest is. If there was only one thing I could choose for you to get out of this read, it would be compound interest. If you’re not completely in awe of the concept yet, I encourage you to read my recent article about compound interestBack to the main topic: you need to do more than just save your money. You need to invest your money (eventually I’ll talk about my personal investing strategies). But the only way you’re going be able to invest money is to, well, have money. 

Myth #3: I need to have a six-figure paying occupation to be rich. 

Yes, it certainly helps to have a six-figure paying job. It’s not an absolute necessity. Far from it. I understand that say, $50,000 in one state may have more buying power than another state. I’m not completely familiar with the cost of living in every state, but I stand by my statement.

If you just invest $438 every month starting at age 25 and assuming you’re earning 6% interest rate, (which is very conservative) you will have $1 million at age 67. Maybe you’re already past that age. Starting at age 30, that monthly contribution would have to increase to $610. The older you are, the more you would have to increase that monthly contribution. This was also based on a very conservative 6% rate. This is why understanding compound interest at a young age is so vital. 

Sure, it’ll take longer if you don’t have a super high paying job. Did anyone say it was a race though? Just keep grinding, live below your means, put your money to work until you eventually reach your goal. Then you can decide how you want to proceed, but why settle?

Picking Your Personal Investment Strategy

 

How you should strategize your investments really depends on your financial situation and the amount of risk you can or want to take. I invest virtually all my money after my expenses. If you’re like me, you’re working in your career field, living with your parents, and have low expenses. I would recommend investing almost everything. Perhaps leave a little cash as an emergency fund. Obviously this comes with a LOT of risk, but if you’re in a position where big expenses such as buying a home is still quite a few years down the road, you can manage this risk. If you have a monthly mortgage or have kids, then I would recommend having at least 6 months of expenses to cover for any unexpected events.

 It can get tricky when you have a lot of debt. I don’t believe paying off all your debt is absolutely necessary before you start investing. I have debt too, but not all debt is created equal.  

For example, credit card debt is very bad. Personally, I think paying off credit card debt should be first priority. Annual Percentage Rates (APR) on credit card debt often times can go north of 20%.  You could choose to have a balance transfer, which can give you 0% interest for a limited time. You need to be cautious when doing this. It doesn’t solve your problem. You still have your debt, and if you don’t pay it off in time, then the balance transfer could end up charging you higher interest than you initially had previously.

Personally I do not have credit card debt, but I do have a little student loan debt and car debt. I am currently not accruing any interest on the student loan debt yet, so I don’t see why I need to rush paying it off. Instead, I’m investing it in places like the stock market. Why pay off debt that is not yet accruing any interest when I can be earning interest in places like the stock market or even high yield savings accounts? Yes, I understand that this can be quite a controversial topic, but that’s an article for another day.  

Now that we’ve discussed how much you’re comfortable investing, I’ll briefly talk about the most common places to invest. I’ve found that many people don’t know how to invest money, so they just don’t do it.  If you don’t know how, props to you for at least reading to learn how. Now, you have to start. Like right now. Stop putting it off. Easiest place to start is the stock market.

It’s not rocket science. Just simply:

  • Open a brokerage account
  • Deposit money in it
  • Invest in stocks, ETFs, REITs, mutual funds, etc.

Robinhood is a great place for beginners. You can buy and sell stocks without being charged any commissions (most brokerages charge a commission for every trade). If you want to start, click here, and you and I will both get a free stock.

You may feel overwhelmed with which stocks to buy and how you could possibly diversify with a limited amount of funds. Later on down the road, I’ll go into more detail about how to decide what companies or funds to invest in. An easy and safe way to get started is buying an index fund or exchange traded fund that mimics the S&P 500 index (500 largest companies by market capitalization). That way, your investment is “diversified” among many companies instead of just a few individual stocks.

Simply put, you are essentially buying shares of stock in a company and becoming a part owner. Ideally, the share price that you bought it at increases over time and you can sell it at a major profit later. An important part about investing in the stock market is riding the volatility and not to panic when the market is in correction. The key is to buy and hold for the long term. So make sure that the money you invest is not money you’re going to need in the short term.

Another place you can invest money is real estate. When you are paying down your home, you are investing in real estate. For some, paying off the home is really important because of the peace of mind that it brings of no longer having a mortgage payment. You could also view a home mortgage as a way that forces you to save. Instead of using your money on discretionary spending, you can make extra payments to the house to gain more equity, or ownership, and paying less in interest. Some decide to rent it out and move to another. Now you have a new stream of revenue coming in. You can also leverage your money and have tenants pay down the principal and provide you with tax benefits like interest and property tax deductions. If you can’t afford real estate, like many Americans, you can invest in Real Estate Investment Trusts (REIT). Essentially, you are investing in a company that manages and operates income producing real estate.  An easy way to invest in these is buying them  on a stock exchange.

Just to recap, here’s what you need to consider before you decide on how and when to invest:

  • Assess your financial situation (Family, house, school, etc.)
  • Build an emergency fund that can pay for at least 6 months of expenses
  • Decide on how to approach your debt, if applicable
  • Determine the amount of investment risk you can take based on age, job security, debt level
  • Choose how you want to allocate assets on your investment portfolio (stocks, bonds, real estate, etc.)
  • Let your money do the rest

Ignoring Compound Interest Can Cost You Hundreds of Thousands

Albert Einstein calls compound interest the “8th wonder of the world. Yet, most people are not familiar with the concept of compound interest. It is one of the most powerful wealth building tools and most people don’t take advantage of it. Conversely, compound interest can work against you. A sad reality is that a shockingly high percentage of Americans end up on the wrong end of compound interest. The longer you wait, the less powerful it is. That is because it is all about how long your money works for you.

I think part of the reason that no one takes advantage of it is because everyone is impatient and they want something that makes them rich now. Another reason is because it may not be very intuitive. I’ll give you an example of what I mean. Say you start the first day of the month with a penny. Then it doubles every single day of the month. At the end of the month (31 days), any guess on how much you’ll have?

$10,737,418.24. Mind blown.

 

Well my mind was blown when I was first told this as a child. Obviously, if it doubles, that is assuming a 100% return, which is a very extreme example. Then again, we did just start with one cent. But what is it that makes the number so large? It’s because you reinvested the interest. I’ll explain what I mean. You invested one cent. You made a 100% return. Now, you have just made one extra cent. Congratulations! You now have two cents. Now you have to reinvest that one cent you just made. So on day two, you’re adding your one cent gain to your original one cent invested. Now you make a 100% gain again. Wow, your portfolio is on fire! Now you have a whole four cents. You get the point. You just keep reinvesting your gain and eventually you end up with $10,737,418.24.

What happens when you don’t reinvest? Well assume you are still getting 100% returns. On the first day, you still gained one cent. However, this time instead of reinvesting it, you spent it. So now on day two, you still have just one cent. Get your 100% gain again, and you earn a penny again. If you never reinvest, you will be making 100% returns on one cent everyday. At the end of the month, you will have earned and spent 30 cents, and you will still have your original penny. I don’t know about you, but I prefer the $10.7 million.

Let’s apply this to a more realistic hypothetical situation.

You invest $1,000. Your average return for the next 30 years is 7%, which is reasonable. If you reinvest and leave it alone for those 30 years, it’ll be $7,612.26.

What does the $1,000 look like after the first 15 years? $2,759.03. As you can see, the growth over the last 15 years is much larger. Time is your friend. Give your money as much time as you can to accumulate and you will see exponential growth.

 

Now what if, instead of 30 years, we let the $1,000 grow for 40 years? By giving your money an extra 10 years, it grows to a whopping $14,974.46. This why you HAVE to invest as early as you can. Do NOT put it off. You aren’t going to get time back. One of the most common regrets people have is not investing earlier. Time is literally money.

Be intentional with your investing. Set concrete goals for yourself. Track your progress. Say you want to be a millionaire in 40 years. If you invest $418 per month for 40 years, you’ll be at just over a million assuming a 7% average return every year. That’s just an example. Personally, I think 40 years too far in the future. Setting a goal that long could be limiting yourself to what you’re really capable of. You can’t predict what could happen in those 40 years. The best way to approach it is set short term and long term goals. Track your progress periodically and adjust your goals accordingly.

One of the biggest hurdles for most people is actually taking action. Then they just put it off and they lose all this precious time. You may feel overwhelmed as to how to invest your money or get out of debt, but that’s why I want to help. The point is that you NEED to get started.