Opening an investment account is a crucial first step to saving wisely. Today, you have the option to invest through a discount brokerage account, a mutual fund account, a full-service brokerage account, or even a bank account. You should pay extremely close attention to fees when choosing an account, since seemingly small yearly charges can act as sharp brakes on the amazing effects of compound interest. Discount brokerages are an appropriate choice for many, since they combine low fees with the widest selection of investment options. It is relatively easy to select a discount brokerage firm since competition has lowered fees substantially.
Why Expenses Matter A Lot
Cooking is something that I have a love-hate relationship with. Although I love being able to control exactly what goes into my body, having an unlimited array of culinary possibilities, and saving money by not eating at restaurants, I hate figuring out what combinations of food will taste good, burning rice for the third time in two weeks, and spending time in front of a stove with a potholder and not in front of a TV with a beer. Frequently the tension of this dilemma is resolved with a takeout order. I am perfectly okay with this, because it is still relatively affordable to outsource this part of my life for $10 a meal or so. But if local takeout places were charging $10,000 a meal, you can bet I would be in a cooking class in no time. No one would eat out at those kinds of prices.
Yet an equivalent price structure exists in the world of investment management, and rather than learning to cook, most people are instead opting to pay $400,000 for a hamburger that has been sitting out in the sun too long.
To see why, let’s bring back Jill and Average Joe.
Imagine each makes an identical $100k investment that earns 8% a year before fees. Jill invests directly in a low cost index fund that charges a fee of 0.2% of assets. Average Joe invests in an average mutual fund through an average financial advisor. The mutual fund charges a management fee of 1.3% of assets (not all funds are as expensive, but 1.3% is about average for an actively managed fund), and his financial advisor charges a fee of 1% of assets for managing the investment on his behalf.
To Joe, it seems like it is well worth it to pay roughly 2% of his assets a year for the convenience of professional management, especially when his investments are easily earning more than this every year. But in actuality he is reducing his returns by a stunning amount over time. After 30 years, Jill’s account would have grown to $952,000 whereas Joe’s account would have grown to only $528,000. Solely by paying 2% a year less in fees, Jill will be nearly twice as wealthy as Joe. The fees that Joe paid did not seem high relative to the returns he was making at the time, but over the course of 30 years they ended up “costing” him $424,000, or four times his initial investment.