Warren Buffett (Trades, Portfolio), considered to be the world’s greatest investor, has made it clear time and time again that investors’ No. 1 goal is to make sure they don’t lose money.
Avoiding companies that may lead to a permanent impairment of capital is a significant part of investing, but there’s another element of investing most overlook; as a result, this issue is one of the most damaging factors in investor returns.
A return inhibitor
The return inhibitor I’m talking about is fees. Investment fees and costs have come down significantly over the past two decades with the rise of low-cost online brokerages and tracker funds. But even though costs have come down over the past few decades, the tendency for investors to overtrade has gone up.
High fees used to provide a barrier for investors to consider when trading; now with costs of $10 per trade or less, investors are almost encouraged to trade. Indeed, some brokerages even offer discount rates for those investors who trade regularly.
This throws up another issue, the issue of tax. If you are constantly trading in and out of positions at a profit, not only are you paying higher fees, but you will also have to pay additional capital gains taxes. Even though you may be doing everything in your power to keep costs as low as possible, when you add the impact of tax on top, long-term returns can be severely compromised.
Fees: an example
The best way to illustrate the wealth-destroying nature of fees is by example. Let’s say you aim for a relatively old retirement age of 70 and start saving at 40 giving you 30 years to put away a retirement nest egg. The provider chosen charges a platform fee of 1% per annum and on top of this, each fund charges 1.5% per annum.
In this scenario, I’m assuming the portfolio grows at an average rate of 10% per annum. An initial $10,000 investment and $1,000 per month contribution would grow to $1.321 million over 30 years including fees. If you strip out the fees, though, the return will be $2.25 million, nearly double the return including relatively high fees.
Even if you search out investment accounts and funds that charge less than 100 basis points per annum in charges, the post-fee long-term returns are still significantly below a nonfee portfolio.
A quick search (by no means comprehensive) revealed the lowest cost platform available to U.S. investors charges 0.35% per annum, and the lowest fund charges 0.25% per annum. Using the same $10,000 initial portfolio with a 10% annual return over three decades, the portfolio in this scenario would end up at $1.955 million, $300,000 less than the no-fee portfolio.
The Robo problem
One of the options available to investors to work their way around this problem is to invest in single stocks, which don’t charge a management fee. However, with Robo-advisers increasingly becoming the go-to investment platform of choice, investors are blocking themselves from this route.
Robo-advisers tend to select a basket of funds for investment and charge a basic platform charge on top.
U.K. Robo-adviser Nutmeg is one of the first of its kind in the country and is trying to revolutionize investing.
The platform charges a basic fee of 0.75% for a managed portfolio or 0.45% for a fixed allocation portfolio for any balances under 100,000 pounds ($124,987). On top of this base fee investors also have to foot the bill for fund fees which can be anywhere from 0.2% to 1%.
Assuming a fully managed portfolio for a basic fee of 7.5% and a portfolio of funds, which commanded average management fee of 0.5% per annum, our $10,000 investor will see a return of $1.72 million over 30 years. These platforms are aimed at millennials so let's take a look at how these fees will impact returns over a longer time frame.
Assuming an initial $10,000 investment, with a $1,000 per month contribution without fees, the portfolio growing at a rate of 7% per annum will be worth $5.4 million at the end of a 50-year period. However, including a charge of 1.25% per annum the final figure drops to $3.4 million. This clearly illustrates how damaging fees can be to your long-term investment returns.
Disclosure: The author owns no shares mentioned.
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