It pays to keep a lid on investment costs

We talk a lot about the costs of investing at MoneyWeek perhaps more than many readers think the topic is worth. After all, picking stocks and funds is the intellectually stimulating part of investment. Trying to keep costs down is more like going around the supermarket working out what brand of washing powder is 25p cheaper this week.

Yet costs matter, as Mebane Faber of Cambria Investment Management demonstrates in a new book* that reviews the long-term performance of a number of popular asset-allocation strategies. His findings show that the difference in performance between the best and the worst strategies can easily be swamped by the impact of costs if investors aren't careful.

Faber's results are broadly what you might expect. At one end of the scale there's the permanent portfolio strategy, developed by investment adviser Harry Browne. This is a very conservative approach that involves putting a quarter of the portfolio into four asset classes: stocks, bonds, short-term government bonds and gold.

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Doing this would have had an after-inflation return averaging 4.12% peryear since 1972, according to Faber. The maximum drawdown (biggest fall from top to bottom at any point) was 23.6%. In other words, it gives you fairly good returns in a relatively consistent way.

On the other hand, a portfolio designed by Mohamed El-Erian (formerly chief investment officer of Pimco) is much more aggressive. He recommends putting around half in stocks of various types, about one-fifth in bonds and the rest in assets such as real estate, commodities and infrastructure, which should provide a buffer against inflation.

This would have returned around 5.96% per year, but had a much higher maximum drawdown of 46.5%. With this approach, you need to put up with much more volatility, but you get rewarded for doing so.

The difference between these two approaches adds up over the long term. If you'd invested $100 in the permanent portfolio in 1972, it would have been worth $525 by the end of 2013 (after adjusting for inflation). The return from investing the same in the El-Erian portfolio would have been twice as much, at around $1,075.

When investmentcosts trump returns

Let's assume that using an adviser costs around 2.25% per year which is very possible, given that some advisers would charge you a fee of around 1%-1.5% per year and use relatively expensive managed funds with total costs of 0.75%-1.25% per year. As you can see from the chart, that would reduce the return on theEl-Erian portfolio below the return on the permanent portfolio. Even a more modest all-in expense of 1.25% would reduce the cumulative return by around 40%.

This illustrates very starkly the importance of keeping control of costs. The good news is that even the El-Erian portfolio could be implemented relatively cheaply today, thanks to the rise of low-cost ETFs. But it's worth noting that that wouldn't have been the case in 1972.

Realistically speaking, it would probably have cost well over 2.25% per year back then, which is itself a warning of the dangers of reading too much into backtested strategies that don't factor in costs.

So how can you minimise costs? First, do as much of the work yourself as you can. That's not to say that you shouldn't consult a financial adviser: good advice can be very valuable, especially when you're starting out.

But paying a fixed fee for a one-off assessment focusing on practical issues, such as how much you need to be saving and whether you have the insurance you need to protect yourself and your family, is better value than paying an ongoing fee to have somebody manage your money.

Second, ditch expensive active funds for cheap ETFs. Studies have continually shown that the average manager underperforms the market after costs. A very small number of managers outperform over the long haul and there is evidence to suggest that some do it through skill (or at least following smart strategies) rather than luck.

But there aren't many of them, so your starting point should always be a cheap tracker fund. Only switch it for a managed fund if you're very confident you've found a manager who is likely to beat the market.

Third, don't trade too much. Not only does overtrading mean you incur excessive trading fees, but it's easy to make bad, impulsive decisions on the back of recent market trends. Instead, manage your portfolio in a methodical way intended to minimise costs: for example, rebalance once a year but only if the actual weight in each asset is more than a certain percentage away from your target.

Lastly, think carefully about taxes. These are in effect a cost of investing, and most calculations of long-term returns don't take into account the taxes that a taxable investor would have paid.

Consider investing through an individual savings account (Isa) or a self-invested personal pension (Sipp) to minimise the amount that you'll lose in tax. Remember that your tax affairs may change in future, so getting investments into a tax shelter is usually a smart move, even if it makes little difference now.

* Global Asset Allocation: A Survey of the World's Top Asset Allocation Strategies, Mebane Faber, mebfaber.com ($2.99)