How Low Fees Drive Much Bigger Returns

Posted on August 7, 2015 at 2:48 PM PST by

You know the mantra: Low fees means money money for you. Every dollar counts.

We usually like to spend less on things we consider ordinary. Who doesn’t love a store-brand bottle of ketchup at a dollar cheaper than the national brand? It feels good to save money.

Except when we don’t. Certain kinds of products just seem wrong to spend less on. Wine, for instance. We know for a fact that plenty of $10 bottles are just fine, and that a $7 bottle of red isn’t going to be 30% lower in quality.

Yet we somehow believe that a $14 bottle is much better and that $40 bottle, wow, it must be amazing.

low fees

In fact, it’s all pretty much grape juice in a fancy bottle with alcohol in it. Time and again, blindfolded wine experts cannot distinguish cheap wines from expensive ones in taste tests.

A similar thing goes on with investing. We know that the cheaper index fund is going to give us the market return every year, like clockwork. Yet we somehow believe it’s worthwhile to pay 2% of our money to a stock broker to see if he can beat that number.

Some years they can. Other years they can’t. Chances drives these outcomes. Yet they take their 2% cut every year, year in and year out. It adds up to a lot of money.

The true effect of those high fees is worse than taking cash out of your account in any given year. What really happens is that your cash is not reinvested on your behalf.

It’s just gone, and that’s it. The years of compounding you would have received from that extra money never happens.

Let’s imagine an investment portfolio of $250,000. The owner of this portfolio has hired a manager who takes 1%. He in turn buys a selection of mutual funds that, added up, take another 1%, each year.

Right off the bat, you’re talking about $5,000. Over 20 years the advisors get to keep and invest that $5,000 for themselves, each and every year. It thus compounds into $371,487, money you never see again.

Let’s say they manage to get you a pretty good overall return, historically speaking, of about 8%. They take 2%, remember? Inflation is going to eat up about 3%. So you’re left with 3% for yourself.

Showing up

That 3% compounds into $451,528. You’ve taken all the risk here and yet the advisors have kept the equivalent of 82% of what you’ve earned without taking on any risk at all. They’re guaranteed that 2% just for showing up.

Viewed another way, they’ve take 45% of your total earnings for effectively on reason at all. After inflation, your money has earned about $823,000, of which you’ve kept just over half.

That’s right, 55% of your money is yours, and 45% has gone to your advisors. Fees matter. Lower them, and you’ll retire with more, automatically.

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