Life Lesson #12: Compounding investment fees – Is it time to panic yet?
While many understand the fundamental concept of compound growth as it relates to investment yield, the expense side of the equation is often overlooked. Advisor investment fees are dismissed or ignored; it’s only 1% after all.
The Story: My wife, Katie, and I love to cook. A favorite holiday recipe makes an appearance almost every year, candied orange peel and cranberry sugar cookies.
We make the candied orange peel from scratch in a boiling, supersaturated sugar solution. Last year, Katie suggested we save the residual orange-infused sugar bath for a future culinary venture.
After the mixture was cool enough to transfer, I poured the liquid into several glass salad dressing containers; one perhaps a remnant of the Should Have Grilled a Steak episode. After the jars were cool enough to handle, I carefully moved them from the kitchen sink to a cookie sheet on the gas range. As I lifted the second one, mid-transfer, something inconceivable happened.
At first, I thought the glass had cracked. As the liquid cooled in the glass jar, however, the bottom somehow broke loose.
Katie often criticizes my threat assessment barometer. Per her observations, according to me everything is a “disaster!” Ants in the house – Disaster! Diaper blowout – Disaster! Blemish on new kitchen table – Disaster!
In seemingly slow motion, like an overweight kid at the community pool doing a cannonball, the sugar solution hit the floor and ricocheted out in every direction. The sticky liquid sprayed onto every cabinet and drawer of the kitchen island behind me. It soaked into the carpet runner in front of the range. It seeped underneath the baseboard between the cabinets and hardwood floor. It splattered both into and onto the drawers under the range and bled into several burners on top. There wasn’t a surface unaffected in an 8-foot radius, including myself.
It was a Colossal Disaster! The Mother Lode of Disasters!
All I could think to do was panic and then retreat to a corner, curl into a fetal position, and scream. As my high-pitched wails resonated throughout the house, Katie came running downstairs to the rescue.
Katie has always been a calming force in my life. While alarmed by the state of affairs, she swung into action and somehow convinced me the world wasn’t going to end.
The Breakdown: Financial advisors claim an analogous benefit: calm clients during tumultuous market corrections. Behavioral finance studies highlight the dramatic cost of emotional investing, which advisors can help prevent. While this may be true, there is a steep hidden cost to this service.
Bear with me while we do a little math. Assume a $100,000 investment, yielding an 8% average return over a 30-year period. In this example, the principle investment will grow to just over $1,000,000. That same investment with an advisor charging a 1% fee has a very different outlook. It will grow to only $744,000. That’s over a quarter of a million dollars less!
Suddenly, 1% doesn’t sound so small anymore.
While advisors offer more benefits than just helping you not trip over yourself in a market correction, there are additional hidden cost hazards as well. Is your money invested in any funds with front-end or back-end load fees? Those will take a bite out of your returns. What about the expense ratios of the funds your money is invested in? If you can’t answer these questions, that’s a problem in and of itself.
Add a 1% expense ratio on top of the advisor fee, and suddenly $195,000 more is removed from your returns. What could have grown to $1,000,000 is now only $549,000.
Now that is a Disaster!
Historical results show that advisors and managed funds are not able to beat market averages over time. You, and only you, are going to be the best steward of your wealth.
Creating a portfolio of low-cost index mutual funds is a lot easier than you think. It’s a hell of a lot easier than cleaning up after a candied orange-peel, sugar-water explosion!