What's a Basis Point?

Source: Capital Pixel

One time, a few years ago, I was explaining to a couple the importance of diversification and why I prefer exchange traded funds to mutual funds and how different funds are used to satisfy an asset allocation.  Basically, an explanation I had given numerous times.  As usual, I ended up by asking if there were any questions. The man said "Just one - what is a mutual fund?"

This taught me the basic lesson that most advisors (but not all!) learn at some point, which is that the jargon that we so glibly use is not familiar to a lot of people.  Furthermore, I'm convinced that it is the single most important point fund reps making 401(k) presentations could work on.  I've attended presentations where reps have droned on and on, enamored with their power point graph, about Sharpe ratios to groups comprised mostly of people who have no idea of the importance of the risk/return tradeoff in portfolio construction much less the ratio between a risk-free rate and a standard deviation.  These meetings remind me of a time when I wandered into a conference seminar on "Advances in Linux" - or something like that.  As far as I was concerned, it could have been a seminar on speaking Swahili - unlike the rest of the audience, I had no idea what the presenter was talking about.

One term that could confuse the layman is "basis point."  We like to say, for example, that a single-A corporate bond yields 111 basis points more than the corresponding U.S. Treasury note.  What the heck does this mean?

A basis point is simply one one-hundredths of a percent.  If one bond yields 5% and another bond yields 5.25%, then the difference is 25 basis points.  You can easily see that talking in terms of basis points is better and more convenient than saying the bond yields 25 one one-hundredths more. Sometimes basis point is shortened to "bips" as in "the bond yields 25 bips more."

Basis Points and Investment Costs

An important area where basis points comes up is in thinking about investment costs.  Investment costs is an aspect of investing that an investor can control.  As is often pointed out, there are parts of the investment process that people obsess over that they, in fact, can't control.  The prime example is the markets.  No amount of gnashing of teeth and towel wringing will change what the market will do.  It is better to focus on what you can control.

Most investors, with a small bit of effort, can reduce investment costs by up to 50 basis points (or bips-- your call on the jargon) by paying attention to expense ratios and talking to an advisor to see if 401(k)s can be rolled over to where less expensive funds are available, etc..

But is it worth it?  Well, consider $100,000 over a 25-year period.  50 bips over this period compounds up to 13.3%, i.e. $13,279 in our example.  Here's the kicker - that money will go into your nest egg or the broker's pocket - your choice.  Furthermore, most investors have a longer time frame - they just don't think it through.  Suppose you are 50 years old.  There is a real good chance that part of your nest egg will be funding your retirement even 35 years from now!

Homework Questions

1. How many basis points difference is the yield between the 10-year Treasury note and the 5-year Treasury note?  Hint:  Go to Bloomberg.
2. What is the basis point difference in the expense ratio between FLCSX (Fidelity large cap stock fund) and SPY S&P 500 exchange traded fund?  Hint:  Go to Morningstar.