Many of my friends don’t have the inclination, confidence or basic spreadsheet skills to be self-reliant investors. They hire a financial advisor so they don’t have to deal with what are very simple tasks for us nesteggers. The time they’d invest to gain modest skills to become self-reliant is likely worth $100,000s. This post expands on a post of three weeks ago: purpose of this post is to describe how to calculate the impact of investing costs on expected future portfolio value. In the example in this post, an investor will effectively pay out ALL of today’s total portfolio value in fees in 25 years.
== The correct way to judge added fees ==
You can’t just look dollar fees paid per year. While the fees you pay are a small percentage of your total assets, they are a much larger percentage of the expected return rate of your portfolio. Your net return rate is lower. The dollar difference from the lower rate grows exponentially. Given enough years the dollar difference in your portfolio will equal the current value of your portfolio.
You should look at it this way: you’re transferring a piece of your portfolio each year to financial professionals – to an advisor and/or to highly paid fund managers if you’re not a nestegger, only investing in index funds. You’re missing the accumulated growth of each piece that you transfer. In concept those professionals invest what you transfer to them each year in a portfolio just like yours without their costs. They accumulate wealth. The amount they accumulate will be many more times the annual payments you make to them. Their gain in wealth is your loss in wealth.
The correct questions to ask are, “What lower percentage return rate do I get to keep because of my investing costs? What’s the impact of that lower return rate in terms of lower portfolio value over time? Am I really getting that much value for what I am paying?”
== Add your total Investing Cost ==
When you invest in a mutual fund or ETF and when you hire an advisor, you incur fees that the financial industry charges fees as a percentage of assets under management, abbreviated as AUM. (You can find advisors who simply charge an hourly fee, which seems a hell of a lot fairer to me; I’ll discuss this in a future post.)
Most folks who hire an advisor think that cost is small – “just 75 basis points,” as a friend of mine told me. Several of my friends have NO IDEA what they pay; this makes ZERO sense me, since the fees are right at the top of their household expenses.
Total Investing Costs also include fund fees – their expense ratio. Actively managed funds have higher expense ratio than the index funds that we nest eggers have in our portfolio. An advisor likely designs a portfolio with at least some actively managed funds. That’s a bet that these fund managers can somehow beat the market to more than overcome their higher costs; we nest eggers know that that’s a poor bet – that’s playing a worse than a zero-sum game. When we add cost to find our total investing costs, we have to assume active fund managers just match market returns before consideration of their costs, and therefore total Investing Costs have to include 100% of their expense ratio.
My “just 75 basis points” friend sent me his recently redesigned portfolio, and I calculated 0.30% as his weighted expense ratio for his funds. I’ll therefore use his total Investing cost of 1.05% in this example (0.75% + 0.30%). I compare that to ~0.05% that we nest eggers spend.
== Direct reduction in your return rate ==
Your investing costs are a direct reduction in the gross return on your portfolio – the expected return before consideration of any investing costs. (The percentage costs likely works out to a little bit lower net return to you than that simple subtraction, but let’s go with that.)
We need to find the impact of that added one percentage point cost on the future value of a portfolio. I’ll use my mix of 85% stocks as the base case for the example: the future expected real return rate using low-cost index funds is 6.4%. One percentage point added cost lowers the net return rate to 5.4% – a 16% reduction in the expected growth rate for this portfolio.
== The differences compound ==
I did two calculations in the post two weeks ago to find out how much portfolio value I was giving up over time: I used Excel’s Future Value calculation for two different returns rates and subtracted the two to see the difference in portfolio value over time.
In our example, the amount paid in a year – 1% of a starting $100,000 equals $1,000 – may not look that significant for a few years. The effects of compound growth are small. The growth portion of a portfolio in five years is small relative to the initial $100,000.
In five years our 6.4% return portfolio has grown by ~$36,000. The 5.4% portfolio has grown by $30,000. The percentage difference in the growth portion is close to the 16% return difference, but the difference in total portfolio value is less than 5%. The $6,000 dollar difference in portfolio value seems reasonable compared to that starting $1,000/year fee. In effect our investor has paid out 6% of his initial portfolio as fees.
Time and compounding magnifies the difference in returns. The growth portion in 20 years is roughly double the initial $100,000.
In 20 years, the 6.4% return portfolio has grown by $244,000. The 5.4% return portfolio has grown of $185,000. The difference in the growth portions is 24%. The difference in total portfolio value is now 17%. The $59,000 dollar difference in value means that our investor, in effect, has paid out 59% of his initial portfolio as fees.
I can add more years in the calculations and find that in a bit more than five more years – +25 years from the start – the difference in portfolio value equals today’s portfolio value in spending power. Our investor has effectively paid out ALL of today’s portfolio value in fees.
(I would get the same answers when I fight through the logic and math of calculating the future value of the growing stream of fees paid – Future Value of Growing Annuity or FVGA. An explanation is here and a calculator is here. The logic of the calcuation is much clearer to me when I do it my way – subtracting the difference in future values.)
== What’s value? ==
Folks have to decide on the value they will get from added investing costs. I think you cannot assume value – net returns greater than index funds – from actively managed funds. A non-obvious cost of advisors is their tendency to put investors in actively managed funds that will return less than index funds. I see the biggest advantage of advisors as preventing folks from making bad mistakes. A friend told me she sold all her stocks in her retirement accounts right before the election, and by the time she got back in the market, she missed 10% return. That’s a bad mistake that will compound to much lower portfolio value in the future. An advisor who would have prevented her from doing that would have provided real value.
Conclusion: The fees an investor chooses to pay that are greater than about 0.05% AUM almost certainly result in lower future portfolio value: the added percentage cost is a direct reduction in the return rate that the investor would otherwise receive. In effect, an investor is transferring a bit of wealth potential from his or her portfolio to financial professionals: in concept they invest it and the amount grows to their future wealth, not yours. This post describes the way to calculate the impact of fees on a portfolio. In the example, an investor effectively pay out ALL of his or her initial portfolio as fees in 25 years.