A Great Example Of Why “Better Returns” Are Often Not All They’re Cracked Up To Be

In a recent post about starting a savings account for a newborn, Jeremy Joslin left the following comment:

I’m doing this for a best friend’s newborn. Problem is that I’m putting the money into a custodial account at my brokerage. I do $20/month but they take $4 per trade. Perhaps the commission isn’t worth the extra rate of return?

My gut reaction is that even over eighteen years, it’s not worth it.

If you put $20 a week into a savings account, returning a 5.05% APY, after eighteen years you would have $29,783.83 in the account. That’s not bad, considering your actual investment is $18,720 – your positive return is $11,063.83.

On the other hand, if you put $20 a week into your brokerage and they take $4 of that in a trade, you’re effectively investing $16 a week and paying $4 to the brokerage. In order to get an amount equal to that savings account, you have to get a 7.8% return on your investment. Now, this is quite possible to do in a brokerage – in fact, I’d say that the possibility is a bit better than 50/50, but you have an awfully high expectation there.

Assuming that you’re planning on giving the child cash that isn’t strictly earmarked for education (if you are, the best choice is a 529 plan handled by a different broker), your best bet is to look at an index fund that is very low in fees. I would take that $20 a week and put it in a savings account until it reached $3,000, then invest it in an index fund at Vanguard (directly through vanguard.com) and put that $20 a week directly into Vanguard rather than the brokerage. There’d be no fee at all and you can get very nice returns out of Vanguard (10-12% at the very least). This would mean amounts closer to $40-50K for that kid when he/she reaches his/her eighteenth birthday.

Even though Jeremy is doing okay over the long haul with the brokerage, the fee is awfully high for that. The better approach is to look for a better brokerage, or to at least change the investing plan (save up the cash in a savings account and do a trade only once a year or so instead of weekly trades). That way, Jeremy and that beautiful baby won’t be nickel and dimed out of a lot of potential gains.

The take-home message? Fees can eat a lot of your investment return so put in the effort to look for lower-fee investment opportunities or at least choose a strategy that minimizes the fees (like minimizing your trades).

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