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Go to college, get a job, meet the right person, move in, maybe get a dog, eventually get married, maybe have some kids, on and on and on. As a newly minted “professional” with a new college degree, I remember feeling like I was on the right path in my life. This was how it was supposed to be, right?
Now that I’ve gone through most of the steps above, and become a bit wiser about money, investing, etc. I’ve been lucky enough to find the FIRE movement and learn how to grow our money responsibly and with an end goal in mind, an end goal that covers our needs and a few of our wants. Unfortunately, many people are unsure how to grow their money without the help of “professional” investors, most of whom charge seemingly small investment fees that will eventually accumulate to undermine wealth over time. The collective confusion and volume of wealth is a breeding ground for nefarious practices. So, I am here to save you from the greedy cesspool with one of the most important lessons you can learn on your Financial Independence journey.
Investment Fees Are the Silent Sneaky Stalking Sinister Assassins of Wealth.
They silently kill wealth for several reasons: they are absolute, appear small, increase the required rate of return to beat inflation, are hidden by account gains, and are likely paying for a service that has no value.
As more people become savvy with their money and use technological innovation to help them with their investment needs, the insidious damage caused by investment fees becomes increasingly transparent. The following breakdown looks at how investment fees will inevitably damage your portfolio balance, the types of fees that seem like nothing at first but accumulate over time, and how to avoid investment fees when planning for a financially independent future.
How Investment Fees Silently Kill Wealth
If you have a basic understanding of how compound interest works, you realize the power that even $1 invested today can have on your financial future. Compound interest is the concept of earning interest on top of interest on top of interest. We love compound interest so much, we even named our Financial Wellness Online Course after it. It is so powerful that even the famous physicist Albert Einstein referred to compound interest as the 8th Wonder of the World. But don’t just take Einstein’s word for it, check out our compound interest calculator to see how powerful it can be over time.
In high school economics classes, it is common to ask students if they would rather take $1,000,000 right now or have a $.01 investment doubled each day for an entire month. While most students jump at $1,000,000, doubling the penny every day results in a whopping $5,368,709.12 after 30 days.
Although it is completely unrealistic to expect to receive a 100% return on investment for 30 straight compounding cycles, this example does demonstrate how much even the tiniest investment can grow over time. Even if the return rate in the example was reduced to a much more reasonable 10% over this same timeframe, that initial $.01 investment would still grow by over 17x by the end of the month.
Despite people having a fundamental understanding of the power of compound interest, many people forfeit much of its benefit in the form of investment fees.
Investment fees ensure the power of compound interest is working AGAINST you, instead of working for you.
Naive investors may skip their monthly date night to be able to invest an additional $50 at the end of the month, yet turn right around and use a different $50 to pay a “professional” firm to manage their account.
Using the same 10% gain from the earlier example, that one-time fee of $50 would have ended up being $850 at the end of 30 years. As investment fees tend to be anything but one-time, it quickly becomes clear how much growing power is lost when handing over even the smallest figures to have your brokerage accounts managed.
Consider the following points to help illustrate why so many people fall into the investment fee trap and allow the “professionals” to slowly bleed their wealth.
Investment Fees Are Absolute
People often quip that death and taxes are life’s only absolutes. For those investors looking to build a financially free future, go ahead and add investment fees to that list.
While market returns, regardless of sector, have been overwhelmingly positive throughout history, there have been plenty of slumps, corrections, and bear markets throughout the years. Recently, the tech collapse of the early 2000s, the housing crisis of 2008, and the COVID-19 pullback of 2020 have all been periods in which investors have seen their nest eggs shrink in a hurry.
Despite these market-induced black swan hemorrhages of wealth, investment fees do not magically turn off. You will continue to have all monthly, quarterly, and yearly fees pulled by your account manager for their “expertise” in helping your account shrink, making the hole from which to recover all the deeper by the time the market turns around.
Investment Fees Appear Small Upfront
Perhaps the greatest trap that investment fees present is their seemingly small cost. Figures such as 2% or $50 may not seem like much, but everything should be considered relatively.
A “measly” 2% may not be much for investors with small account balances. After all, if you open an account with an initial deposit of $1,000, that 2% service fee is only $20. You can’t even get out of McDonald’s for less than $20 these days.
However, it is always important to think long-term with your investments. That 2% becomes $200 by the time your account reaches $10,000, $2,000 by the time it reaches $100,000, and $20,000 (enough to pay for several months of total living expenses) by the time the account reaches $1,000,000. And that 2% fee will be assessed each period between these thresholds.
For accounts that charge one-time transaction fees, consider that an admirable savings goal for the average American is around $500 per month; if a firm is charging $50 per transaction, that is a 10% reduction in purchasing power. While this is detrimental when purchasing mutual funds and index funds, it is potentially catastrophic when picking high-upside stocks. Imagine if you missed out on $50 worth of Amazon stock when it was trading at $1.50 per share! (we don’t recommend beginners picking individual stocks, but the point still stands!)
Investment Fees Increase Rate of Return to Beat Inflation
Although the figures vary among the experts, most investors try to secure at least a 7% return on investment each year. As the cost of inflation usually increases, on average, roughly 2-3% each year, investors need their portfolios to yield 9% to reach their investment goals.
However, when investment fees are taken into consideration, this required return increases. A 2% fund management fee on top of 2% inflation means that accounts must return at least 11% to ensure the minimum target of 7% yearly growth. Even the most optimistic investors are hesitant to count on market returns greater than 10%.
To complicate matters for the contemporary investor, 2021 is expected to see higher-than-normal inflation as the economy emerges from the pandemic, with professional forecasts predicting at least a 2.5% hike.
So, assuming that funds were withdrawn from a brokerage account and capital gains taxes were assessed, investors would theoretically be losing money after fees, inflation, and taxes, if their account did not yield more than 4.5% in 2021. With inflation increasing, investment fees become even more important to avoid.
Investment Fees Are Hidden Behind Account Increases
Another insidious aspect of investment fees is that they are hard to spot amid account growth. As mentioned, markets tend to increase over time, meaning that when investors periodically check their account balances, they will see a larger figure than the last time they checked. For those used to seeing their money stagnant in a savings account, this is very exciting.
However, what they are overlooking is where the account could have been had investment fees not been applied. In most cases, balances would have been hundreds—if not thousands—of dollars greater had no fees been applied, but because people are generally happy to see growth in their accounts, they tend to ignore what might have been. And you can bet most financial advisors charging investment fees are doing everything they can to help you ignore these fees as well.
Investment Fees May Be Paying for Something with No Value
Recent data indicates that 85% of actively managed large-cap funds will underperform the S&P 500. This means that you would be better off putting your money into an index fund that passively mimics the broader market than paying fees to someone who will provide you a diminished return. We recommend reading JL Collins incredible book, “The Simple Path to Wealth”, which covers this topic with complete mastery and will create a stock master out of you as the reader!
If you are the type of investor that does not relish the idea of buying into all of the losing stocks listed on an exchange, you are likely to be just as well off picking your own portfolio on a commission-free platform as paying a professional to pick for you (there is an actual study of a tabby cat randomly picking winning stocks with more success than experienced professionals).
The Math Behind How Investment Fees Kill Wealth
To build on the evidence and rationale listed above, Nerdwallet did a helpful breakdown of how investment fees will undermine your account balance over time.
In their example, a hypothetical investor deposited $500 per month into a mutual fund for 30 years, using a conservative 7% growth rate for the fund’s yield. They analyzed the cost of investment fees at different percentages, with the results listed below:
As you can see, even a small .25% fee leads to a loss of growth in excess of $25,000 over the 30 years, while the more standard 1-2% will see losses exceed $100,000.
Types of Investment Fees
From annual percentages to one-time expenditures, there are several ways that investment fees can eat at your account balance and growth potential. For many funds, investors will be assessed more than one of these fees throughout the life of their account. The following looks at the different types of investment fees and how they are assessed.
Brokerage Fee
This is a fee charged by the stockbroker who handles your account. Some of the types of fees that fall under the brokerage fee umbrella include:
- Annual fees - typically a $50 to $75 annual charge for managing the account
- Inactivity fees - penalties for not making deposits or withdrawals that can exceed $200 per year for large accounts
- Research and date fees - costs associated with your broker subscribing to premium information services
- Account closing or transfer fees - usually a $50 to $75 fee for closing an account or moving funds to a different platform
Trade Commission
This is sometimes referred to as a stock trading fee. This is when your brokerage charges you to buy or sell shares.
These types of fees are on the decline as investors continue to demand commission-free trading platforms. However, there are still brokerages that will charge between $3 to $7 per trade, with fees reaching as high as $50 when purchasing stocks listed on foreign exchanges.
Mutual Fund Transaction Fee
If a mutual fund does not charge a brokerage fee, there is a high likelihood that it charges a mutual fund transaction fee. This is charged by the brokerage when buying or selling funds.
Most brokerages charge for both buying and selling, while some charge only when buying. Fees will typically range anywhere from $10 to $75.
Expense Ratio
Expense ratios are charged by mutual funds, index funds, and ETFs. They are assessed as a percentage of your investment and charged as an annual fee.
The expense ratio is designed to cover operating and administrative costs. It will be higher for actively managed mutual funds (usually greater than 1%) than for passively managed index funds and ETFs, which will likely have a fee of around .25%.
Sales Load
Some mutual funds will be designated as “load funds.” These are marketed as superior management funds, but, as seen earlier, increased management may not be a good thing. When choosing a load fund, investors may be assessed fees between 3% to 8.5% in the following ways:
- Front-end load - these are upfront charges that will be subtracted from your investment amount, similar to a trade commission
- Back-end load - these fees are charged when shares of the fund are sold. These are typically very difficult for the investor to calculate
- Level load - this is typically an additional 1% fee if shares of the fund are sold within the first year
Sales loads are very avoidable for discerning investors. Simply make sure that the selected fund is “no-load” before opening the account.
Management or Advisory Fee
This is the costly fee associated with a professional’s expert management. Although advisors may charge as a percentage of assets under management, on an hourly basis, or through an upfront retainer, the final costs will usually end up being roughly 1% of the account value.
401(k) Fee
Employer-sponsored retirement plans tend to be expensive due to the high administrative costs and low selection of products. In most cases, the employer will pass these expenses onto the account holder, meaning that a lower percentage of withheld dollars contributes to growth.
It can be beneficial to max out retirement contributions if your employer pays these 401(k) administrative fees. If not, contribute just enough money to activate your employer match and use the extra in a lower-cost alternative.
How to Avoid Investment Fees
Although the evils of investment fees have been expounded throughout this article, you still may be unsure how to actually invest while keeping fees to a minimum. The following looks at some best practices that can help in this regard.
Choose Low-Cost ETFs and Robo-Managed Funds
As with many facets of life, technology has vastly reduced sales commissions, significantly lowering costs for the end consumer. The same logic applies to wealth creation, as robo-managed accounts will have much smaller fees than those actively managed by an investment professional.
In addition, consider the advantages of investing in low-cost ETFs as opposed to picking specific stocks. As these broad, passively managed funds regularly outperform actively managed funds, they are likely your best bet for growing your wealth. Vanguard, Fidelity, and Schwab all offer low-cost ETF options (some as small as .05%). Although compound interest is incredibly powerful, it does need some steam to get kicked off, and .05% isn’t really enough to warrant a concern given our average life expectancy.
Choose Commission Free Trading Platforms
If you insist on picking stocks, it is likely that you can do just as well as a professional investor. Technology and instant information have created so much volatility in the markets that traditional stock-value metrics are of dubious efficacy in the contemporary world. Research companies in high-growth sectors, choose management with integrity, and be prepared to hold on amid the volatility to give yourself the best chance of success.
If you choose to go this route, be sure to take advantage of the many commission-free platforms available (Robinhood, Interactive Brokers) to avoid paying trade commissions each time you buy or sell. But again, we don’t recommend this approach.
Read the Fine Print
If you absolutely MUST use a brokerage, they are required by law to disclose their fees before opening an account. Therefore, use the information provided in this guide to look out for any potential fees. Understand that not all fees are upfront and that there may be some that rear their ugly heads down the road.
Remember that even seemingly small figures, when listed in the fine print, can significantly undermine future growth.
Conclusion
The power of compound interest is a concept that is generally understood by most people. However, many novice investors forfeit its full power by handing over investment fees to professional firms and account managers.
Although they appear small and harmless, investment fees are regularly occurring drains on your account that are hidden amid your account growth and will ultimately end up undermining your ability to achieve financial independence.
What should I do next?
If you are just getting started on your path to Financial Independence, we recommend check out our Beginner’s Guide to FIRE. Once you’ve calculated your time horizon to financial independence, we strongly encourage you to start tracking your money. We believe that Personal Capital is the most comprehensive free financial tool you can find online to manage your finances and track towards your FI date.
We love the free features Personal Capital offers, including the ability to:
- Track and manage your income and expenses
- Track your net worth
- Analyze your investment portfolios for excessive fees (this is especially important early on in your FI journey)
- Analyze your investment portfolios for proper asset allocation
- Run various retirement planning calculations with their amazing retirement calculators
Our favorite financial management tool is free to use and take less than a minute to sign up. Though you must create Personal Capital login credentials to use them, you don't need to enroll in Personal Capital's advisory service. As you may know, we always try to avoid fees whenever possible. We also strongly recommend fee-only financial advisors, so you know how much you're paying up front and avoid advice with conflicts of interest. By signing up with Personal Capital for free and aggregating all your accounts in one place, you'll be well on your way toward financial independence.
Start Tracking Your Investments with Personal Capital
Additional Reading/References:
The Investment Fees to Ask About Before You Invest – The Balance
When 2% Costs Everything: How Investment Fees Cost You Your Freedom | ChooseFI
Understanding Investment Fees: From Brokerage Fees to Sales Loads - NerdWallet
The Power of Compounding – $1 Million Now or Penny Doubling for a Month | $aving to Invest (savingtoinvest.com)
2021 Inflation Forecast Heads Higher | Morningstar
Stock picking has a terrible track record, and it’s getting worse (cnbc.com)
