Why Fees Matter

The absolute first thing I look at when comparing investments is the fees that are charged on that investment. I look at it before I look at the history of that investment or anything else.

Why am I so interested in the fees? There are two reasons.

First, the fees charged on your investments are real and take a major bite out of how much you earn. Fees are the percentage of money that investment houses take out of your investment each year so that they can earn revenue. Investment firms tend to earn a lot of revenue and the vast majority of it comes from these fees. This is big money.

Second, past performance is not indicative of future returns. You can make some guesses based on past history, but you certainly can’t make a reliable prediction about what will happen in the future. You can’t even really compare funds all that well unless they’re invested in extremely similar things.

I’m going to show you step-by-step how much fees matter in an investment.

Our Generic Investment

For simplicity’s sake, I’m going to use a very simple investment to show the impact of fees. In this example, I’m going to say that we’re investing $5,000 a year at the start of the year in a particular investment. Over the course of that year, it earns a 7% return – each and every year, like clockwork. At the end of the year, the investment house takes out their fee and we start all over again by adding the next year’s $5,000 investment.

You are going to be shocked as to how much impact fees have over the course of a long-term investment.

Example 1: A Low-Fee Investment

In this example, we’re going to look at an index fund that charges only a 0.05% annual fee for management. That’s very, very low – you might find a fund or two that low, but not many. Vanguard, my preferred investment firm, tends to have fees between 0.05% and 0.3% or so on their index funds.

During the first year, the investment will earn 7% – $350 – bringing your balance to $5,350. You’ll then be charged that 0.05% fee, bringing the total down to $5,347.33. Your fee cost you $2.67.

After five years, your total investment will be worth $35,718.26. Your fees will have taken up only $48.20 of your total investment (the total fee, plus the 7% annual that fee would have earned you had it not been slurped away). Not bad, right?

After ten years, your total investment will be worth $78,694.61. Your fees will have cost you $223.39.

After twenty years, your total investment will be worth $222,939.84. Your fees will have cost you $1,386.05. Again, not too bad, right?

After thirty years, your total investment will be worth $505,276.47. Your fees will have cost you a total of $5,088.74.

Finally, after forty years, your total investment will be worth $1,057,904.60. Over the course of all of that time, your fees will have cost you a total of $15,143.25. Your total fees add up to about 1.4% of your total investment.

Now, $15,000 doesn’t seem too bad considering your investments now total more than a million dollars. However, remember this is pretty much the best investment you can find out there.

Let’s look at a middle-of-the-road example.

Example 2: A Middle-of-the-Road Investment

Here, we’re going to look at an index fund that charges only a 0.3% annual fee for management. That’s pretty average. It’s pretty high for an index fund, but pretty low for an actively managed mutual fund. Let’s see how this one goes.

During the first year, the investment will earn 7% – $350 – bringing your balance to $5,350. You’ll then be charged that 0.3% fee, bringing the total down to $5,333.95. Your fee cost you $16.05.

After five years, your total investment will be worth $35,478.29. Your fees will have taken up $288.16 of your total investment.

After ten years, your total investment will be worth $77,588.29. Your fees will have cost you $1,329.70. This is pretty close to what you were charged over the first twenty years with the 0.05% fund.

After twenty years, your total investment will be worth $216,154.06. Your fees will have cost you $8,171.83.

After thirty years, your total investment will be worth $480,666.01. Your fees will have cost you a total of $29,699.19.

Finally, after forty years, your total investment will be worth $985,600.07. Over the course of all of that time, your fees will have cost you a total of $87,447.78. Your total fees add up to about 8.9% of your total investment.

Over the course of a forty year investment, a 0.05% fee costs you about $15,000, whereas a 0.3% costs you about $87,500. That difference in fees, which seems like such a little deal, is removing $72,500 from your pocket over the course of that investment.

That’s not even a particularly bad investment, either. Let’s look at an expensive one, shall we?

Example 3: An Expensive Investment

Here, we’re going to look at a fund that charges a 1% annual fee for management. That’s on the high side, but there are still a lot of investments out there that charge more than this. Ready to be scared?

During the first year, the investment will earn 7% – $350 – bringing your balance to $5,350. You’ll then be charged that 1% fee, bringing the total down to $5,296.50. Your fee cost you $53.50.

After five years, your total investment will be worth $34,815.16. Your fees will have taken up $951.29 of your total investment.

After ten years, your total investment will be worth $74,583.01. Your fees will have cost you $4,334.99.

After twenty years, your total investment will be worth $198,375.11. Your fees will have cost you $25,950.78. Now, for comparison’s sake, a 0.05% fee investment will have only charged you about $15,000 over the course of the full forty years of investing.

After thirty years, your total investment will be worth $418,608.23. Your fees will have cost you a total of $91,756.98. For comparison’s sake, even the middle-of-the-road 0.3% fee investment will only have charged you about $85,000 over the course of forty years of investing.

Finally, after forty years, your total investment will be worth $810,415.39. Over the course of all of that time, your fees will have cost you a total of $262,632.46. Your total fees are worth about 32% of your investment.

Over the course of a forty year investment, a 0.05% fee costs you about $15,000, whereas a 0.3% costs you about $87,500. That difference in fees, which seems like such a little deal, is removing $72,500 from your pocket over the course of that investment.

Some Comparisons

First of all, let’s look at total balance. Remember, we’re putting the same amount in each year. With the 0.05% investment, your balance at the end of 40 years is $1,057,904.60; with the 0.3% investment, it totals up to $985,600.07; and with the 1% investment, it totals up to $810,415.39.

Now, this is a pretty typical example of retirement savings for someone starting at age 25. By choosing a 0.05% fee investment instead of a 1% fee investment, that person ends up with $200,000 more in their retirement account at retirement age.

You can do similar comparisons. I like to look at the comparison of the total percentage of fees versus the total percentage of the value of the investment. In other words, what percentage of the investment was eaten up over 40 years by both the fees themselves and by loss of value in the investment?

With the 0.05% investment, only 1.4% of the total value was lost to fees. With the 0.3% investment, 8.9% of the total value was lost to fees.

With the 1% investment? 32% of the value was lost to fees. 32%!

Conclusion

Here’s the real story: when you’re comparing investments that are similar at all, one of the first things you should look at are the investment fees. How much does it cost to buy into this investment? What are the annual fees going to look like?

Even a seemingly small difference in fees – like 0.05% versus 1% – makes a gigantic difference in what your total retirement will end up looking like. Even tiny differences like 0.05% versus 0.3% can make a huge difference – tens of thousands of dollars over a reasonable history of saving for retirement.

You don’t have to be an investment expert to take a serious look at the fees being charged on your investments and give some priority to the ones charging lower fees. It’s this fee difference that causes me to choose index funds most of the time, because my goal is to simply come close to matching the average of whatever I’m invested in with the least amount of fees possible – and that’s exactly what index funds provide.

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