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Costs and the market return

Why investors as a group must earn the market return minus their costs.

FinanceBogle ch. 4About 3 min: 2 reading, 1 practiceUpdated

General education, not financial advice.

After this lesson you can
  • Explain why investors as a group earn the market return before costs
  • Show how yearly costs compound over time
  • Judge a cost by its long-run effect
Money over time: lesson 5 of 5
  1. Mankiw ch. 14
  2. Compound interest 5 min
  3. Present value 5 min
  4. Mankiw ch. 11
  5. Measuring inflation with a price index 4 min
  6. Real and nominal interest rates 3 min
  7. Bogle ch. 4
  8. Costs and the market return 3 min

Try first

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Pairs with Bogle, The Little Book of Common Sense Investing (2007), chapter 4, "How Most Investors Turn a Winner's Game into a Loser's Game"

What it is

This lesson explains an argument made by John Bogle, who started the first index mutual fund. It is simple arithmetic:

  1. All investors together own the whole market, so before costs they earn exactly the market's return. For every investor who beats it, another falls behind by the same amount.
  2. Investors pay costs: management fees, trading costs, sales charges. So after costs, investors as a group must earn less than the market, by exactly what they paid.

Bogle's summary: before costs, beating the market is a zero-sum game; after costs, it is a loser's game.

Quick check

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  1. All investors together, before costs, earn…

    Show answer

    the market's return. Together they own the whole market.

Why it matters

Costs are taken every year, whether returns are good or bad, and they compound like interest in reverse. A cost that looks small in one year can take a large share of the gain over a working lifetime.

Worked example

10,000 grows for 30 years at 6% a year before costs.

  • With no costs: 10,000 × 1.06³⁰ ≈ 57,400.
  • With costs of 1.5% a year, it grows at about 4.5%: 10,000 × 1.045³⁰ ≈ 37,500.

Costs take about 20,000, roughly 42% of the 47,400 the money would otherwise have gained. (The figures are rounded, and the costs Bogle quoted were from 2007; they have changed since.)

Common mistake

Judging a cost by its size in one year. "1.5% is tiny" ignores that it is charged every year on a growing balance. Always look at what it adds up to over the whole time you will hold something.

Key terms

market return
the return of the whole market
expense ratio
a fund's yearly running costs, as a % of what you hold
zero-sum
one side's gain is another side's loss

Practise the key terms

Tap a card to turn it over. 3 cards.

FrontBack
market returnthe return of the whole market
expense ratioa fund's yearly running costs, as a % of what you hold
zero-sumone side's gain is another side's loss

Practice

Try the same numbers with costs of 0.2%, then 2.5%.

What yearly costs take

Drag a slider and watch the result change.

For learning only. Real accounts have fees, taxes and changing rates.

Quick quiz

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  1. Before costs, what do all investors together earn?

    Show answer

    Exactly the market return. Together they own the whole market, so together they get its return.

  2. Why do investors as a group fall behind the market after costs?

    Show answer

    Because the costs are subtracted from the market return. The group gets the market return, minus everything it paid out.

In short

  • Before costs, investors as a group earn the market return.
  • After costs, the group must earn less, by exactly what it pays.
  • Costs come every year and compound, like interest in reverse.
  • Judge a cost by what it takes over the whole time you hold something.

Mastery check

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Check yourself

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  1. What does "zero-sum before costs" mean here?

    Show answer

    One investor's gain over the market is matched by another's shortfall, so the group earns the market return.

  2. Name two kinds of investing cost from the lesson.

    Show answer

    Any two of: management fees, trading costs, sales charges.

  3. Why does a yearly cost matter more over 30 years than over 1 year?

    Show answer

    It is taken every year and compounds, so it reduces each later year's growth as well.

Further reading

  • John C. Bogle, The Little Book of Common Sense Investing (John Wiley & Sons, 2007), chapter 4.
  • Investor.gov, the U.S. SEC's investor education site, which explains fund fees in plain language.