When people shop for items ranging from toothpaste to a car they typically focus on costs or fees, with the understanding that the less they spend the more money they keep. However, when it comes to investing fess, most people ignore costs and instead focus on past investment returns, which always include the caveat that past performance is no guarantee of future results. This mindset can have a detrimental effect on long-term investment results.
There are two main costs for the average investor; the fee you pay for the investment vehicle you choose to invest in, and the fee you pay to your financial advisor to manage your assets. It should be noted that this article assumes you are not buying individual stocks or bonds through a broker and instead invest in mutual funds or exchange-traded funds and pay an asset-based fee for investment advice.
First, let’s examine how the fee you pay for the investment vehicle in which you invest can affect you over the long term.
In this scenario, we have two types of portfolios valued at $100,000 which are both managed by the same financial advisor who charges a 1% management fee. The first portfolio is comprised of actively managed mutual funds with half invested in stocks and half invested in bonds. Each mutual fund charges an expense ratio on top of the fee charged by the financial advisor. This expense ratio varies from fund to fund depending on the investment mandate.
The Mutual Fund Example
For this example, the Large Cap Growth Mutual Fund has an expense ratio of 1.17% while the Core Bond Mutual Fund charges .80%. The total fee for the mutual funds and the financial advisor is 1.985% per year of the assets that are managed.
If the investment portfolio returns 8% annually over 30 years you would have $576,792.40 net of the mutual fund and financial advisor fees. Sounds pretty good, but before we get too excited let’s review the second portfolio.
The ETF Example
This portfolio is comprised of exchange-traded funds (ETFs) with half invested in stocks and half invested in bonds. ETFs are similar to mutual funds in that they allow an investor to diversify by owning multiple stocks with the purchase of one share of an ETF. However, they differ in that they are passively managed and trade throughout the day on a stock exchange.
One ETF share offers exposure to a basket of stocks which can represent a broad market such as the S&P 500, a specific sector like energy, or a specific commodity like gold. Expense ratios for ETFs are much lower than those of actively managed mutual funds; for example, in this portfolio the Large Cap Growth Exchange Traded Fund is .20% while the Core Bond Exchange Traded Fund is .24%.
The total fee for the exchange-traded funds and the financial advisor is 1.22% per year of the assets that are managed. If the investment portfolio returns 8% annually over 30 years you would have $715,644.75 net of the exchange-traded fund and financial advisor fees. The difference between Portfolio 1 and Portfolio 2 is a whopping $138,852.35!
The second major cost for individual investors is the asset management fee you pay your financial advisor. These fees can vary greatly from 1% to as much as 3% per year.
It’s Only a .5% Difference
If the financial advisor mentioned in the previous two scenarios charged 1.5% percent instead of 1%, Portfolio 1 would have a final value of $500,525.37 – or $76,267.03 less. Portfolio 2 would have a final value of $621,650.62 or $93,994.13 less.
As you can see, investment costs have a direct negative impact on the long-term value of your investment portfolio.
I will leave you with the following thought from a very successful and well-known investor, Warren Buffet. “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals (actively managed mutual funds).”
If you haven’t recently reviewed your investments you should contact your CERTIFIED FINANCIAL PLANNER™ Practitioner.