Two Big Reasons to Watch Your Investment Fees Like a Hawk
John Bogle, the founder of Vanguard, once said: "In investing, you get what you don't pay for."
That may sound strange, but it’s true. In fact, minimizing your investment fees is one of the easiest and most powerful ways to increase your odds of success. Here’s why.
1. Low Fees Lead to Better Returns
This is pretty counterintuitive. We're used to better things costing more money and cheap alternatives meaning important sacrifices. But it's the exact opposite when it comes to investing.
In 2010, Morningstar released the results of a study in which they found that cost was the single best predictor of a mutual fund's future investment return. The lower the cost, the better the future return. In other words, in investing, the cheap alternatives aren't a sacrifice at all. They're actually the higher quality items and they increase your odds of success.
2. Even Small Fees Cost You a Lot of Money!
You may think that a 1% difference in cost isn't that big a deal, but over long periods of time it adds up to a huge difference. Let's put aside the fact that lower cost investments typically outperform and assume that you'll get a 6% return no matter what.
Now let's say that you're saving $5,500 per year (the annual maximum for an IRA) and you have two investment choices: an index fund that costs 0.10% per year or an actively managed fund that costs 1.10% per year.
After 10 years, here's your balance in each fund:
- Low-cost fund = $76,412
- High-cost fund = $72,230
- Difference = $4,182
Here it is after 20 years:
- Low-cost fund = $211,969
- High-cost fund = $188,770
- Difference = $23,198
Finally, here's what it looks like after 30 years, which is a pretty standard amount of time for most people investing for retirement:
- Low-cost fund = $452,449
- High-cost fund = $376,801
- Difference = $75,648
What would you do with an extra $75,000?
Fees to Watch out For
How can you tell how much your investments are costing you? Here's a quick rundown of some of the most common types of fees.
Expense ratios - Every mutual fund and ETF has an expense ratio that's expressed as a percentage (e.g. 0.10%). This is the percent of your account balance that is taken each year to pay the fund's expenses.
Sales loads - These are commissions paid to investment salesmen. Many financial advisors make money this way, which is one reason why it makes sense to seek out a fee-only financial planner.
Trading fees - Some investment platforms charge you a fee to make trades or perform other actions.
Management fees - Financial planners, automated platforms like Betterment, and even some 401(k)s charge a fee when they manage your investments for you.
Know What You're Paying and Why
To be clear, not all fees are bad. For example, there are times when it makes sense to pay a little extra for professional guidance to make sure that you're making the right decisions.
However, you should make sure you know what you're paying and why you're paying it. Eliminating unnecessary fees is one of the easiest ways to increase your odds of investment success.
Image from CRA Financial