If you’ve made it this far into The Personal Finance Playbook, you know a few key things about investing.
- The stock market, despite its crazy ups and downs, always goes up over the long run and investing in it is essential to outpace that sneaky money-eating monster inflation.
- By using a set it and forget it approach, you will outperform nearly every investor over time because no one can predict stock prices.
You also know I’m a huge fan of utilizing a simple, passive approach to investing with low-cost index funds to take full advantage of the first two points. Notice that I said low-cost index funds. What does low-cost mean and why is it important? The answer: it’s all about fees.
A Quick Lesson on Fees
Fees come in many forms, but the two most prominent fees and the ones we will focus on today are expense ratios and management fees.
Expense ratios are the fees that funds charge you to invest in them each year. These fees can vary, depending on how expensive the fund is to operate. Actively managed funds may charge a fee of 1% or higher because they need to pay sophisticated fund managers to buy and sell individual stocks, a research team to help analyze the markets and a nice big expensive office (with a view) to house everyone in.
So if an actively managed fund returns 6% this year and charges a 1% expense ratio, your investment return will be 5%. They take their cut and you get what’s left over.
Passive investing strategies such as index funds are able to charge substantially less in fees because there is no stock picking involved. Index funds are hands-off and automatically mirror whatever benchmark they are tied to. There are no head honchos making millions of dollars a year here.
So expense ratios for some low-cost index funds like the Total Stock Market index fund from Vanguard can be as low as 0.04% or, in other words, 96% less in fees than the average actively managed fund.
Management fees are what you pay a financial advisor to manage your investment portfolio. These fees are expressed as a percentage of your assets under management, so as your portfolio grows, so do the fees you pay each year to have it managed for you.
For example, if you pay a 1% management fee when your account is $50,000, you will pay your advisor $500 that year. But if your portfolio grows to $500,000, you will pay your advisor $5,000. Got it?
If your investments are managed by an advisor, you will pay the expense ratios on the individual investments plus a management fee, which is deducted from your account each year.
Now I’m not saying management fees are bad because not everyone wants to manage their own investments. But you must take fees into account here or it will end up costing you big time in the long run. This is where robo advisors have become a game changer.
Services like Wealthfront and Betterment provide a diversified portfolio of low-cost index funds based on your risk tolerance and time horizon. These companies employ a team of world-renowned economists and financial planners that build an optimal allocation of low-cost domestic, international and bond index funds and rebalance your portfolio whenever it gets slightly imbalanced due to market movements.
The key difference is in the technology. Everything is done automatically, meaning that the management fee can be significantly lower than a traditional financial advisor who has to manually do these tasks for each client.
While traditional advisors charge management fees in the vicinity of 1% per year or higher, Wealthfront and Betterment charge a flat 0.25% fee for their services. It is the definition of hands-off investing.
The Hidden Truth About Fees
Now I know I’ve thrown a lot of numbers at you so thanks for staying with me. Time to put this into practical terms. Let me introduce you to two friends of mine who will help tell a story about the dangers of fees, Active Arnold and Passive Pete.
Active Arnold relies on a traditional financial advisor to create and manage his investment portfolio for him. This particular advisor wants to prove that she can beat the market and puts together a portfolio of actively managed mutual funds with an average expense ratio of 1% while also charging Arnold a 1% management fee. A pretty competitive rate for a financial advisor these days.
So Arnold invests $8,000 each year for 40 years with this financial advisor. Lucky for Arnold, his advisor happens to pick actively managed funds that are able to perform as well as the overall stock market with an annual return of 6.8% after inflation (a nearly impossible statistical feat since nearly all actively managed funds underperform the market over time).
After 40 years, Arnold’s investment portfolio grows to $900,670 in today’s dollars after fees. Pretty solid, right?
Passive Pete decides to invest $8,000 each year with a robo advisor which provides a diversifed portfolio of low-cost index funds that easily achieves the market’s average return of 6.8% annually after inflation, but with an average expense ratio of just 0.10% and a 0.25% management fee.
After 40 years, Pete’s portfolio grows to $1,380,254 in today’s dollars after fees or, wait for it…
Nearly $480,000 more than his buddy Arnold.
The Bottom Line
We know that investment returns compound over time, but the hidden truth is, so do fees. If you want to utilize a financial advisor you trust to manage your investments, it’s absolutely okay with me. But you need to understand exactly what you are signing up for and make sure to ask questions if you don’t.
And while I recommend robo advisors for those that want a hands-off approach to long-term investing, the only way it will work in your favor is if you continue to invest on a regular basis regardless of how the market performs. If you sell your investments when the market is down, it’s all for nothing.
Remember the Fidelity study? The best-performing investors were dead and still had their accounts open. Ignore the ups and downs, no matter how scary the downs may seem, because spring always follows winter.
Both Wealthfront and Betterment allow you to automate your investments by setting up recurring deposits from your bank account which really helps take the emotion out of investing. Just remember key facts 1 and 2 at the top of this article and you will build tremendous wealth over time.
Fees are one of the only components we can control as investors and the decisions you make today can literally save you hundreds of thousands of dollars over your investing lifetime.
Albert Einstein said it best long ago, “Compound interest is the eighth wonder of the world. He who understands it…earns it, he who doesn’t…pays it.”