This post was originally made on July 20, 2006 on a former blog of mine.

As you may by now I am hyper analytical about the fees one pays in order to generate investment returns. Fees are, after all, one of the only things truly in your control. The following bit of writing is an excerpt from yesterday’s Trend Desk article at Yahoo Finance. You’ll have to scroll to page 2 to see this part. The article is written by Daniel Pink and provides some awfully revealing scientific research about how people (even smart people) treat mutual fund fees. Do mutual funds really have a magical quality about them causing us to completely ignore their fees??? Read the excerpt and then I will have some comments below.

A Yale economist, a Harvard economist, and a Penn economist walk into a room….

No, this isn’t a joke. It’s actually not funny at all. A trio of economists fitting this description did walk into a room not too long ago, and they uncovered additional evidence of a disturbing trend: Individual investors don’t pay attention to mutual fund fees.

In a fascinating new paper, this threesome describe a set of experiments designed to probe investors’ sensitivity to fees. The researchers gave subjects prospectuses of four S&P 500 index funds and asked them to allocate $10,000 among the funds. Then they divided the subjects into three groups.

One, the control group, got just the prospectuses. The second group received the prospectuses along with an additional sheet that summarized the fees for each fund. The third group got the prospectuses along with a summary sheet that highlighted each fund’s “annualized returns since inception.”

Now, Yahoo! Finance readers would know what to do here. Since the index funds are identical, you put all your money into the fund with the lowest fees. That sheet about annualized returns that the third group received is a red herring. Since each fund is tracking exactly the same basket of stocks, any differences in annualized returns since inception reflect merely when the fund was started. It doesn’t offer any guidance about future returns.

What happened? In the group with just the prospectuses, more than 95 percent failed to maximize their returns by minimizing their fees. But maybe that was because the fee information was buried in the fine print. Alas, more than 80 percent of the subjects in the second group — the one that got a separate sheet explicitly listing the fees — didn’t allocate all their money to the lowest-cost fund. And the third group was even worse: These folks chased the funds with the “best” returns even though that information was irrelevant — and they ignored the fees, the only relevant data they had.

The subjects must have been rubes, right? Uh, not exactly. They were actually Harvard and University of Pennsylvania undergraduates and Penn MBA students. MBA students!

I am left baffled by the results of this test. As I mentioned in Controlling the Controllable, the fees you pay are one of the only things you can control in your world of investing. Why not pay close attention to them?

If you said to someone, “hey, I can get you 1%+/yr better returns than you are getting right now without taking on more risk” then wouldn’t they be borderline insane not to listen to you? One would think so, however this is the exact proposition that was essentially given to the MBA students mentioned above and they were unable to make the proper decision.

Shaving a percent or two off your fees is the safest way to improve your returns. I prefer to shave fees by building my own portfolios of stocks with similar risk profiles to a basket of mutual funds. That solution is not practical for everyone especially if your account is too low to warrant buying 30-40 individual assets. One CAN however be super conscious of the fees they are paying to the mutual funds in their portfolios and reduce fees by switching into similar funds with lower expenses. Contrary to popular opinion, fee payments are not correlated with long term fund performance. Two large cap value funds will probably have very similar expected return profiles over any long duration of time. If one charges higher fees than the other then this seems like a no brainer.

Watch your fees! Watch your fees! Watch your fees!

“Nature makes only dumb animals. We owe the fools to society.” -Honore de Balzac

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