Reader Travis B. sent in a list of Ask GFC personal finance questions, and this was one of them. It's an excellent question too, because investment fees can be deceptive. Relatively low fees can seem harmless, but over time they can really mount up. As they accumulate, they have a strong negative impact on your long-term return on investment. And if you've been investing for a while, you know that means plenty!
You see, the “secret” to successful investing has a lot to do with the time value of money. You can invest at a given rate of return over a certain amount of time, and it will enable your money to grow as if by magic. But as impressive as that might be, a higher return on your investment will produce even better results. Over 10, or 20, or 30 years the improvement can be incredible.
While it's true that a small difference in fees might not make a difference in the very near term, the disadvantage grows with time. Let's take a look at the effect of both a 0.5% and a 1.00% increase in investment fees on the performance of a portfolio over the very long term, as well as some other fee-related factors.
What a Difference of “Only” 0.5% Can Make
Let's say that you have a choice between two investment services. One charges an annual fee of 1.0% to manage your account, while the other charges just 0.5%. In most respects, the two platforms provide the same level of service. The only significant difference between the two is the annual investment fee. How much of a difference does it make?
Your choice between the two investment services involves a portfolio of $100,000, and an average expected rate of return of 7.0% per year.
If you go with a service that charges 1.0% per year to manage your account, your effective net return on investment will be 6.0%. That's the 7.0% expected rate of return, less the 1.00% investment fee charged by the service.
If you invest your portfolio with that firm for the next 30 years, your portfolio will grow to $574,350. If you never understood the impact that small changes in investment fees can make on your portfolio, you might be satisfied with that return.
But if you invest your portfolio with a service that charges just 0.5% per year to manage your account, your effective net return on investment will be 6.50%. Once again, that's the 7.0% expected rate of return, less the 0.5% investment fee charged by the service.
If you invest your portfolio with that firm for the next 30 years, it will grow to $661,438. The difference in return over 30 years amounts to $87,088.
That's an enormous advantage, considering that the only thing you did differently was to invest your money with a service that charges a lower annual fee.
Naturally, the difference will be even more significant with an even bigger difference in the investment fee.
What a Difference of “Only” 1.0% Can Make
Let's look at the same scenario here. You have a portfolio of $100,000, and an expected annual rate of return of 7.00%. You have a choice in having your money with one of two services, the first charging 1.5% per year to manage your portfolio, while the second charges just 0.5%. That's a difference of a full percentage point on the investment fee.
If you go with the first broker, your effective annual rate of return on your investments will be just 5.5%. That's the 7.0% expected annual rate of return on investment, less the 1.5% annual investment fee charged by the broker.
After 30 years, your $100,000 will grow to $498,397.
From the example above, we already know that by investing your money with the broker who charges just 0.5% to manage your portfolio, your investment will grow to $661,438. The difference in return over 30 years amounts to $163,041!
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Once again, the only thing you did differently in the second scenario is to invest your money with a lower-cost investment service.
Notice that in a single year, the difference in investment fees might only add up to $500 or $1,000. But over three decades, it amounts to tens of thousands of dollars. The impact of the lower annual investment fee grows with each passing year, as the portfolio grows in size. This is when it's important to remember that we're not talking about flat dollar amounts, but percentages.
In a real way, higher investment fees represent the compounding of money in reverse. That is, they have a way of magically and silently eating away at your wealth over time.
Investment Fees Mean Even More if You're an Active Trader
Investment fees these matter even if you are a self-directed investor who does not make use of professional investment management services. The fees just take a different form. Instead of the service charging you an annual investment management fee based on a percentage of your portfolio, the primary cost is transaction fees.
Here's where a difference of just a few dollars per transaction can matter. And if you are an active trader, they matter a lot.
Even within the discount investment brokerage field, there can be a major difference in transaction fees, such as commissions on trades. At the lower end of the scale, you can find brokerage firms that charge a commission of less than $5 per trade. But on the higher side, trading fees can be as high as $10 per trade.
The difference of $5 between the two commissions isn't a deal breaker if you are only making a few trades per year. But if you are a very active trader, making hundred trades per year, that seemingly small difference can add up to real money.
As an example, let's say that you have $100,000 in your portfolio, and you expect to make 200 trades per year. That's 100 purchases, and 100 sales.
If you go with a broker who charges $10 per trade, you will pay $2,000 per year – 200 trades at $10 each – in commissions over the course of the year.
If on the other hand you go with a broker who charges $5 per trade, you will pay just $1,000 per year – 200 trades at $5 each – in commissions over the course of the year.
Now the long-term effect of the difference in total annual trading commissions work a little bit differently than it does with percentage-based investment management fees. After all, when we're talking about trading commissions, were really talking about flat fees.
In this case, the difference in trading fees will be $1,000 per year. If you average 200 trades per year for the next 30 years, that means that you will save $30,000 over that time span by using the lower cost broker.
That's certainly not as dramatic as is the case with differences in investment management fees. But once again, you're earning a higher return just as a result of using lower-cost brokerage firm. It's easy money!
Actually, the advantage could be even higher than that. The thousands of dollars that you save in commissions using the lower cost broker would provide you with more capital to invest, and to earn more money going forward.
When Higher Fees Might be Justified
While keeping investment fees to a minimum should always be a goal, there are times when paying a higher fee may be justified.
This is mainly in the case where you are an inexperienced investor, who needs a higher level of service in the form of professional investment management. You may have no interest in trading securities on your own, nor in managing a portfolio. In this case, you should be perfectly willing to pay someone else to handle it all for you.
But even in this situation, there are less expensive ways to get the job done. For example, traditional investment managers charge an annual management fee of 1% or more of your portfolio. But there are online automated investment services that can perform similar management for a lot less in fees.
This includes “robo advisors” – investment platforms in which you open up an account, have your risk tolerance and investment goals evaluated, and then a portfolio is created and managed for you. From that point forward, all you need to do is fund your account on a regular basis.
The largest and most popular robo advisor is Betterment. They will provide automated investment management for annual fees ranging from 0.15% to 0.35%, depending upon the size of your account.
The difference between paying 1.00% per year for a management fee, and 0.35% with Betterment will be huge over time. Not only that – unless you have several hundred thousand dollars to invest, most traditional investment management services won’t even accept you as a client. Betterment, on the other hand, allows you to open up an account without any money at all!
There's almost always a less expensive place to invest your money. Do a little bit of digging, and find out where they are. Small differences in investment fees can add up to hundreds of thousand dollars over the long run.