Editor’s Note: We’d like to welcome our newest guest author, the immensely talented personal finance expert Carlos Sera. Carlos, who also writes the blog Financial Tales will be sending us original stories on occasion, so check back often.
My 22 year old daughter graduated with a marketing degree in May of 2009 and started her first professional job in August. Having grown up around me, she knows that she should save at least 15% of every paycheck. I am very happy to report that my preaching, or nagging as she would call it, did not fall on deaf ears and in November she asked how she should invest her 15% from every paycheck. This time I told her something I have never told anyone before. Normally I would have said she should invest in a low cost, no load mutual fund. However, this time I told her to wait until the end of the year and then invest in one of the 8 commission-free Exchange Traded Funds, or ETFs, that Charles Schwab had at that time recently announced would be introduced by year end. I’ll tell you why soon.
She asked me what an ETF was and I explained that ETFs were stocks that owned a collection of assets such as stocks and bonds, but that most importantly, they are what I call the next generation of mutual fund. The only thing preventing the ETF from going viral on the investment public was the cost to buy and sell them in small quantities. Once Schwab removed the cost barrier, Fidelity Investments responded by announcing that clients would be able to trade 25 popular ETFs at Fidelity commission free as well. The dominoes are all in a line and soon I expect the trading of ETFs at no commission will be universal and you will also see them start to populate the fatted calf of investment fees called the 401k. There is no stopping the ETF now that the veil has been lifted. In my opinion, the mutual fund had its day in the sun and all but the most competitive both in pricing and performance will be displaced by the ETF. So for my daughter and for every reader, learn as much as you can about ETFs. There are hundreds of them and I will write about them at a later date but today I will focus on why I recommended that my daughter wait. The answer is cost.
Let’s look at cost in the framework of expected returns from investing in stocks. Suppose a person wants to invest $200 per paycheck in the stock market. This is called Dollar Cost Averaging. In the case of the stock market, let’s assume that a 22 year old starts to invest and the stock market averages 10% per year over their lifetime. What happens however, if the cost to invest the $200 every pay period is $20? Simple math will tell you that $20 is 10% of $200. So in the first year all of the return is eaten up in fees. With commission-free investing this is no longer the case. Companies like Schwab and Fidelity and I am sure the others that will soon follow have found a way to eliminate this $20 fee and now the small investor no longer has this problem.
This transformative shift in the cost structure of how small investors can participate in the stock market will go a long way to accumulating wealth in America. The victor will clearly be the investor and those companies that can deliver the commission-free ETF in a low cost, yet profitable manner. The clear loser will be the mutual fund industry.
You can read a detailed explanation of Dollar Cost Averaging how it works by reading A Tale of Perspective from my Financial Tales library.
