Our minds have strange ways of tricking us with numbers, and this is never truer than when it comes to investment fees over the long term.
I’ve always been good at math, but I didn’t always realise the importance of investment fees on returns. I would think, “1% difference, who cares?”
For some reason, in my mind I would think of 1% in absolute terms. For example, if I have an investment fund of $10,000 and am deciding between a fund that has 0.5% in fees and a fund that has 1.5% in fees, the difference is only $100. $50 vs $150 respectively. For the hope that the 1.5% fee fund will have a better return, that doesn’t seem like a big compromise to make.
As we know though, higher fees do not guarantee higher returns.
So it would be easy for me think that over a period of 30 years, that a 1% difference in fees will result in a 1% difference in returns. Not much in the scheme of things is it? Even on a $500,000 portfolio, that is a difference of just $5,000.
But that calculation is wrong. So very wrong.
Fees should not be calculated against the size of your portfolio. They need to be calculated against your returns.
There’s no better way to see how big an impact a 1% difference in fees can make through an example.
We will assume there are two investors: Kelly and Fiona. They both invest $10,000 a year and both achieve returns (before fees) of 7.5%. The only difference is Kelly pays 0.5% in investment fees, and Fiona pays 1.5%. A difference of 1%.
Kelly - 0.5% investment fees
Fiona - 1.5% investment fees
Kelly has ended up with just over a million dollars, and Fiona with $838,000. A difference of $173,000. Kelly achieved 24% more in investment returns than Fiona.
The higher the investment returns or contributions and the bigger the dollar differential will be.
The lower the investment returns or contributions, and the bigger the percentage impact will be.
So this is just a reminder of the huge difference 1% can make over time. Because if you were like I used to be, you won’t believe the difference could be this big.
A 1% difference in fees over 30 years can easily be a difference of 25% in returns.
One thing we can control is fees. No one can guarantee us higher returns and if something is higher cost with no guarantee of higher returns, then that to me is not a good product. That is why low cost index funds are such a great option.
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