Everything we buy in life has a cost . . . and a benefit. The catalyst to a buying decision is usually determining whether the cost is worth the benefit. Think about it! If we want to buy a car, we will evaluate whether $20,000 is a fair price for a specific brand and model. The reality is everyone has a different opinion of what is fair because they have a different opinion of what determines a benefit.
For example, I think a sunroof at $250 is a bargain. Others might choose air conditioning which costs more as an option but they think its worth it. Some might even choose to buy both options.
More importantly, why is it that some people buy an entry level Hyundai while others are willing to spend the bucks on a top of the line Mercedes?
My point is simple – YOU CANNOT EVALUATE A COMMODITY BASED ON COST AND COST ALONE.
The investment industry is not all that different
Many people have criticized mutual funds for having Management Expense Ratios (MER) that are too high. These same people believe you can buy stocks on your own for far less money than the MERs you are paying for the average mutual fund. They may be correct, but they have not factored in the benefit side of the equation.
Others think that MERs are justified because the average investor is unable to select stocks properly, especially if you are talking about global investments. These same people may not have the access, expertise, time, knowledge and desire to manage their own portfolios. In their mind MERs are a bargain if they make money. They, too are correct.
The investment industry is interesting by the fact that there are many different vehicles and paths to achieve the same goals. Just like there are many ways to get from Edmonton to Vancouver, there are many ways to get a 10% rate of return. You can buy individual stocks, bonds, or mutual funds. You can be a buy and hold investor or a market timer. You can implement a value discipline or a growth. They all work but at different times.
Recently, Jonathan Chevreau reviewed my book in the National Post and asked me to comment on the relevance of fees. Fees are important and a fund with an above average MER is at a disadvantage because that fund must work harder to deliver the same net returns. My belief is that I am willing to pay for a higher MER if that fund delivers a benefit for the incremental cost. In the end VALUE = BENEFIT – COST which applies to everything in life, too!
How do you measure the benefit?
This is a difficult question to answer. The most logical would be returns. If an investment returned 25% with a cost of 5% we might determine there is good value in this investment. Conversely, and investment with a low cost of 0.5% but returning a meager 3%, would be substandard even to frugal thinker.
There are other more technical approaches to measuring the benefit like the Sharpe Ratio, Treynor Ratio, trailing returns, and average returns. In any case, you can plot a graph with the benefit on one axis and the cost on the other and try to determine the funds that give you the ‘Best Bang for Your Buck. – otherwise known as the best value.
Don't get caught up in cost alone. There is much more to investing than just cost. In the end, I have always preached multi-dimensional analysis, which simply put means you never look at a fund from one perspective or based on one criteria. This means you will not look at only performance, risk, management, company or fees. The best approach is to look at all of these to give you the best overall picture!