BEFORE WE TURN TO the success of indexing as an investment strategy, let’s explore in a bit more depth just why it is that investors as a group fail to earn the returns that our corporations generate through their dividends and earnings growth, which are ultimately reflected in the prices of their stocks. Why? Because investors as a group must necessarily earn precisely the market return, before the costs of investing are deducted.

When we subtract those costs of financial intermediation—all those management fees, all of that portfolio turnover, all of those brokerage commissions, all of those sales loads, all of those advertising costs, all of those operating costs, all of those legal fees—the returns of investors as a group must, and will, and do fall short of the market return by an amount precisely equal to the aggregate amount of those costs. That is the simple, undeniable reality of investing.

In a market that returns 7 percent in a given year, we investors together earn a gross return of 7 percent. (Duh!) But after we pay our financial intermediaries, we pocket only what remains. (And we pay them whether our returns are positive or negative!)

Before costs, beating the market is a zero-sum game. After costs, it is a loser’s game.

There are, then, these two certainties: (1) Beating the market before costs is a zero-sum game. (2) Beating the market after costs is a loser’s game. The returns earned by investors in the aggregate inevitably fall well short of the returns that are realized in our financial markets. How much do those costs come to? For individual investors holding stocks directly, trading costs may average 1.5 percent or more per year. That cost is lower (maybe 1 percent) for those who trade infrequently, and much higher for investors who trade frequently (for example, 3 percent for investors who turn their portfolios over at a rate above 200 percent per year).

In actively managed equity mutual funds, management fees and operating expenses—combined in what we call a fund’s expense ratio—average about 1.3 percent per year, and about 0.8 percent when weighted by fund assets. Then add, say, another 0.5 percent in sales charges, assuming that a 5 percent initial sales charge were spread over a 10-year holding period. If the shares were held for five years, the sales charge cost would be twice that 0.5 percent figure—1 percent per year. (Many funds carry sales loads, now often spread over a decade or more. About 60 percent of funds are “no-load” funds.)

But then add a giant additional cost, all the more pernicious by being invisible. I am referring to the hidden costs of portfolio turnover, which I estimate average a full 1 percent per year. Actively managed mutual funds are said to turn their portfolios over at a rate of about 80 percent per year, meaning, for example, that a $5 billion fund buys $2 billion of stocks each year and sells another $2 billion, a total of $4 billion. At that volume, brokerage commissions, bid-ask spreads, and market impact costs add a major layer of additional costs that are borne by fund investors, perhaps 0.5 to 1.0 percent.

We investors as a group get precisely what we don’t pay for. If we pay nothing, we get everything.

Result: the “all-in” cost of equity fund ownership can come to as much as 2 percent to 3 percent per year.¹ So yes, costs matter. The grim irony of investing, then, is that we investors as a group not only don’t get what we pay for. We get precisely what we don’t pay for. So if we pay nothing, we get everything. It’s only common sense.

A few years ago when I was rereading Other People’s Money, by Louis D. Brandeis (first published in 1914), I came across a wonderful passage that illustrates this simple lesson. Brandeis, later to become one of the most influential jurists in the history of the U.S. Supreme Court, railed against the oligarchs who a century ago controlled investment America and corporate America alike.

“The relentless rules of humble arithmetic.”

Brandeis described their self-serving financial management and their interlocking interests as “trampling with impunity on laws human and divine, obsessed with the delusion that two plus two make five.” He predicted (accurately, as it turned out) that the widespread speculation of that era would collapse, “a victim of the relentless rules of humble arithmetic.” He then added this unattributed warning (I’m guessing it’s from Sophocles): “Remember, O Stranger, arithmetic is the first of the sciences, and the mother of safety.”

Brandeis’s words hit me like the proverbial ton of bricks. Why? Because the relentless rules of the arithmetic of investing are so obvious. (It’s been said by my detractors that all I have going for me is “the uncanny ability to recognize the obvious.”)

The curious fact is that most investors seem to have difficulty recognizing what lies in plain sight, right before their eyes. Or, perhaps even more pervasively, they refuse to recognize the reality because it flies in the face of their deep-seated beliefs, biases, overconfidence, and uncritical acceptance of the way that financial markets have worked, seemingly forever.

It’s amazing how difficult it is for a man to understand something if he’s paid a small fortune not to understand it.

What’s more, it is hardly in the interest of our financial intermediaries to encourage their investor/clients to recognize the obvious reality. Indeed, the self-interest of the leaders of our financial system almost compels them to ignore these relentless rules. Paraphrasing Upton Sinclair: It’s amazing how difficult it is for a man to understand something if he’s paid a small fortune not to understand it.

Our system of financial intermediation has created enormous fortunes for those who manage other people’s money. Their self-interest will not soon change. But as an investor, you must look after your self-interest. Only by facing the obvious realities of investing can an intelligent investor succeed.

How much do the costs of financial intermediation matter? Hugely! In fact, the high costs of equity funds have played a determinative role in explaining why fund managers have lagged the returns of the stock market so consistently, for so long. When you think about it, how could it be otherwise?

By and large, these managers are smart, well-educated, experienced, knowledgeable, and honest. But they are competing with one another. When one buys a stock, another sells it. There is no net gain to fund shareholders as a group. In fact, they incur a loss equal to the transaction costs they pay to those “Helpers” that Warren Buffett warned us about in Chapter 1.

Investors pay far too little attention to the costs of investing. It’s especially easy to underrate their importance under today’s three conditions: (1) when stock market returns have been high (since 1980, stock returns have averaged 11.5 percent per year, and the average fund has provided a nontrivial—but clearly inadequate—return of 10.1 percent); (2) when investors focus on short-term returns, ignoring the truly confiscatory impact of costs over an investment lifetime; and (3) when so many costs are hidden from view (portfolio transaction costs, the largely unrecognized impact of front-end sales changes, and taxes incurred on fund distributions from capital gains, often realized unnecessarily).

Perhaps an example will help. Let’s assume that the stock market generates a total return averaging 7 percent per year over a half century. Yes, that may seem a long time. But an investment lifetime is now actually even longer than that—65 or 70 years for an investor who goes to work at age 22; begins to invest immediately and works until, say, age 65; and then continues to invest over an actuarial life expectancy of 20 or more years thereafter. Now let’s assume that the average mutual fund operated at a cost of at least an assumed 2 percent per year. Result: a net annual return of just 5 percent for the average fund.

$10,000 grows to $294,600 . . . or to $114,700. Where did that $179,900 go?

Based on these assumptions, let’s look at the returns earned on $10,000 over 50 years (Exhibit 4.1). Assuming a nominal annual return of 7 percent, the simple investment in the stock market grows to $294,600. Why? The magic of compounding returns over an investment lifetime. In the early years, the line showing the growth at a 5 percent annual rate doesn’t look all that different from the growth in the stock market itself.

But, ever so slowly, the lines begin to diverge, finally resulting in a truly dramatic gap. By the end of the 50-year period, the value accumulated in the fund totals just $114,700, an astounding shortfall of $179,900 to the cumulative return earned in the market itself. Why? The tyranny of compounding costs over that lifetime.

In the investment field, time doesn’t heal all wounds. It makes them worse. Where returns are concerned, time is your friend. But where costs are concerned, time is your enemy. This point is powerfully illustrated when we consider how much of the value of the $10,000 investment is eroded with each passing year (Exhibit 4.2).

By the end of the first year, only about 2 percent of the potential value of your capital has vanished ($10,700 vs. $10,500). By the 10th year, 17 percent has vanished ($19,700 vs. $16,300). By the 30th year, 43 percent has vanished ($76,100 vs. $43,200). And by the end of the 50-year investment period, costs have consumed 61 percent of the potential accumulation available simply by holding the market portfolio, leaving only 39% for the investor.

You put up 100 percent of the capital and you assume 100 percent of the risk. But you earn less than 40 percent of the potential return.

In this example, the investor, who put up 100 percent of the capital and assumed 100 percent of the risk, earned less than 40 percent of the potential market return. Our system of financial intermediation, which put up zero percent of the capital and assumed zero percent of the risk, essentially confiscated 60 percent of that return.

I repeat: What you see in this example—and please don’t ever forget it!—is that over the long term, the miracle of compounding returns has been overwhelmed by the tyranny of compounding costs. Add that mathematical certainty to the relentless rules of humble arithmetic described earlier.

Simply put, our fund managers, sitting at the top of the investment food chain, have confiscated an excessive share of the returns delivered by our financial markets. Fund investors, inevitably at the bottom of the food chain, have been left with a shockingly small share. Investors need not have incurred that loss, for they could have easily invested in a simple, very low-cost index fund tracking the S&P 500.

Costs make the difference between investment success and investment failure.

In short, the humble arithmetic of investing—the logical, inevitable, and unyielding penalty assessed by investment costs—has devastated the returns earned by mutual fund investors. Using Justice Brandeis’s formulation, our mutual fund marketers seem “obsessed with the delusion” that investors capture 100 percent of the stock market’s return—and are foisting that delusion on investors.

When our fund marketers cite the stock market’s historical annual return of 9.5 percent since 1900 and ignore fund expenses of 2 percent and inflation of 3 percent, they suggest that investors can expect a real, after-cost return of 9.5 percent. Well, to state the obvious, they shouldn’t. You need only add and subtract for yourself. The truth is that the real return to investors equals (you guessed it!) only 4.5 percent.

Fund investors deserve a fair shake.

Unless the fund industry gives its investors a fair shake and improves the net return that it delivers to fund shareholders, it will falter and finally fail—a victim, yes, of the relentless rules of humble arithmetic. Were he looking over your shoulder as you read this book, Justice Brandeis surely would be warning you, “Remember, O reader, that arithmetic is the first of the sciences and the mother of safety.”

Costs make the difference between investment success and investment failure. So, sharpen your pencils. Do your own arithmetic. Realize that you are not consigned to playing the hyperactive management game that is played by the overwhelming majority of individual investors and mutual fund owners alike. The low-cost index fund is there to guarantee that you will earn your fair share of whatever returns—positive or negative—our businesses earn and their stock prices and dividends deliver.