The most valuable pieces of advice ever shared regarding investing of any kind, in ascending order of importance:

1. Fundamental analysis is crucial. Technical analysis is akin to fortune telling by interpreting patterns in tea leaves.

2. It's not a game or a hobby. Spend hours researching an investment when others are spending minutes. Spend days when others are spending hours. Done right, you'll still enjoy a stupendous return on your time.

3. You make your money going in.

It's straightforward math, and easy to overlook or dismiss in its simplicity. An overpriced asset is that much harder to gain a return on than an underpriced or properly priced one. Wait for a real estate bubble (or, say, the hoopla surrounding a social networking site's much-anticipated initial public offering) to subside and then buy; your margin for error and potential for return should increase correspondingly.

SEE: A Guide To Investor Fees

The Price of Management
We're not talking about normal price fluctuations, here, or the inherent unpredictability that comes with almost any investment. Rather, we're looking at what's essentially a surcharge on the price of the investment, levied before you buy. For example, take two new cars with the same model, same color and same options. One dealer sells the first vehicle for $22,000, "out the door." The other sells the identical vehicle for $22,000, but with a $495 non-negotiable "advertising and marketing assessment." Do you need to be told to buy the former? It's like purchasing a residential air filter in Vancouver, Washington (and paying 8% state sales tax) instead of going across the river and buying the same thing in Portland (Oregon levies no sales tax).

This is how it goes with mutual funds, the financial product of choice for most casual and many sophisticated investors. While no two funds are indistinguishable, two similarly constituted funds can come with price tags that differ considerably. Why? Varying expense ratios.

It's understandable that a mutual fund's price costs more than the prices of its components. It costs money to create a fund. The fund has to be set up, registered and maintained. The firm that created it and that hired its managers has to be compensated. However, to what tune? The U.S. Securities & Exchange Commission (SEC) requires (and common sense recommends) that mutual fund issuers list each of their funds' annual operating expenses, breaking them down by category (e.g., management fees, distribution fees) and adding them together in an item called "total annual fund operating expenses" (alternatively, for our purposes and parlance, expense ratio). It's the premium you pay to the issuer on top of the price of the fund itself.

Mutual fund companies make it easy for you to comparison shop with regard to expense ratio. They tell you the minimum you'll lose before you purchase; if only people who manage other types of investments were that big on disclosure. If you think expense ratios are close to uniform, they aren't.

Take American Growth Fund, a fund issuer out of Denver. Its Class C Shares (AMRCX) have one of the largest expense ratios we could find. A staggering 5.68% of your investment goes toward paying the American Growth Fund manager(s) and other expenses, such as mailing out updates. Contrast that with Strategic Advisers' U.S. Opportunity II Fund (FUSPX). (If you've never heard of Strategic Advisers, it's a subsidiary of leviathan Fidelity Investments.) This particular fund is larger than the American Growth Fund's C shares by several orders of magnitude, but it's the expense ratio of 0.02% that gets a conscientious investor's attention.

SEE: Stop Paying High Mutual Fund Fees

Differences in Returns
The differences in expense ratios aren't just numbers in a column. They make a palpable impact on your bottom line. Say you want to invest $5000 in each of the two funds. The former fund acknowledges that you'll be out $284 before a single one of its components starts trading. Buy a position in the latter and you'll be out one dollar. Granted, expense ratios fluctuate from year to year and from fund to fund under the same issuer, but few people are willing to pay an extra $284 to take a seat at the blackjack table before the dealer even cuts the deck.

If the difference between a 5.68% expense ratio and a 0.02% expense ratio seems significant now, you should see it in a decade. Assume that each fund shows a nominal (pre-expense) 10% return, year in and year out. If you didn't take expense ratios into account, you'd figure the funds would be interchangeable.

However, if you did (as you should) look at expense ratios, the difference is vast and unmistakable. In over 10 years, that $5000 investment would turn into $7,632.13 when invested in a fund with a 5.68% expense ratio. Buy the fund with the .02% expense ratio and with the same nominal return, you'd pocket $12,945.15 (or 70% more). Compounding really is the most powerful force in the universe.

The Bottom Line
Look at components when you buy a mutual fund. Look at your own objectives, such as growth and income; however, never treat expense ratio as an afterthought. It might be the most underappreciated criterion in all of investing.

Related Articles
  1. Mutual Funds & ETFs

    Mutual Funds Are Not FDIC Insured: Here Is Why

    Find out why mutual funds are not insured by the FDIC, including why the FDIC was created and how to minimize your risk with educated mutual fund investments.
  2. Professionals

    How to Sell Mutual Funds to Your Clients

    Learn about the various talking points you should cover when discussing mutual funds with clients and how explaining their benefits can help you close the sale.
  3. Professionals

    Tax Efficient Strategies for Mutual Funds

    Before you sell mutual fund shares, consider these tax strategies first.
  4. Professionals

    Fund and ETF Strategies for Volatile Markets

    Looking for short-term fixes in reaction to market volatility? Here are a few strategies — and their downsides.
  5. Investing

    How Diversifying Can Help You Manage Market Mayhem

    The recent market volatility, while not unexpected, has certainly been hard for any investor to digest.
  6. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  7. Personal Finance

    How To Choose A Financial Advisor

    Many advisors display similar skillsets that can make distinguishing between them difficult. The following guidelines can help you better understand their qualifications and services.
  8. Investing Basics

    Diversifying Your Portfolio: 5 Easy Steps

    You can never be sure of what the market will do at any given moment. That’s why a well-diversified portfolio is so important.
  9. Mutual Funds & ETFs

    Is Your Financial Advisor Picking the Right Mutual Funds?

    Learn about the different types of mutual funds and how to know if your financial advisor is choosing the right funds for you based on your investment goals.
  10. Mutual Funds & ETFs

    Understanding Lipper Ratings in Mutual Funds

    Take a closer look at the Lipper rating system for mutual funds and exchange-traded funds (ETFs), how investors should interpret it, and some possible criticisms.
  1. Can mutual funds invest in hedge funds?

    Mutual funds are legally allowed to invest in hedge funds. However, hedge funds and mutual funds have striking differences ... Read Full Answer >>
  2. What are the risks of annuities in a recession?

    Annuities come in several forms, the two most common being fixed annuities and variable annuities. During a recession, variable ... Read Full Answer >>
  3. Do financial advisors get paid by mutual funds?

    Financial advisors are reimbursed by mutual funds in exchange for the investment and financial advice they provide. A financial ... Read Full Answer >>
  4. Why is fiduciary duty so important?

    Fiduciary duty is one the most important professional obligations. It basically provides a much-needed protection for individuals ... Read Full Answer >>
  5. When are mutual funds considered a bad investment?

    Mutual funds are considered a bad investment when investors consider certain negative factors to be important, such as high ... Read Full Answer >>
  6. Why do financial advisors have a fiduciary responsibility?

    Financial advisors governed by fiduciary duty are bound by law to act in the best interests of their clients at all times. ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  2. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  3. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  4. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
  5. Cost Accounting

    A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step ...
  6. Capitalized Cost

    An expense that is added to the cost basis of a fixed asset on a company's balance sheet. Capitalized Costs are incurred ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!