Many investors don't pay a whole lot of attention to fees. Because of that, they give up a lot of their returns. Lately, more investors are becoming cognizant of fees, but there are still many who are in the dark.
Investment professionals need to charge fees to keep in business. Like any business, investment professionals have to make a living, but investors should know the true cost of that advice. In other words, investors should know what they get for the price that they pay.
While a 1 or 2 percent fee doesn't seem like a lot to many investors, it has a significant effect upon their long-term returns. The central point that many investors fail to understand is that fees have long-term effects as a result of compounding.
The simple formula for compounding is as follows:
Investment amount times (1+ interest rate) to the power of the years invested.
For example, investing $50,000 at an 8% rate for 20 years is $50000*(1.08)^20 or 233,047.86. A 2% fee brings down their rate of return to 6%. So the return after the fee is $50,000 *(1+ .06)^20 or 160,356.77. The fee costs them $72,691.09 (233,047.86-160,356.77).
Furthermore, the $50,000 was the investors original investment, so 183,047.86 was earned at 8% (233,047.86-50,000) and 110,356.77 was earned at 6% (160,35677-50,000). Dividing the 6% return by the 8% return, the investor is giving up 40% of their enfire investment returns (1 minus (110,356.77 divided by 183,047.86)). That is the actual effect of the fees on a compounded basis!
It is critical to understand the effect that compounding has on investment returns.
Attached are a number of scenerios to understand the cost of the fees paid. The last column - "Growth Cost of Fee" provides a numerical value of how much a fee is reducing investment returns.
Key points:
- Compounding increases at an increasing rate the higher the interest (or fee) rate
- Compounding increases at an increasing rate the longer the investment period
All serious investors should fully understand the concept of compounding or they are just "flying in the dark". "Flyng in the dark" is a good way to get hurt!
Be safe, be smart, be prepared, be well read and be successful!
