Compound Interest. It’s a financial concept so awesome that the most famous scientist of the 20th century has a quote about it:
“Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.” – Albert Einstein
Or maybe it was this:
“The most powerful force in the universe is compound interest” – Albert Einstein
Or actually, maybe he never said anything about compound interest at all. It doesn’t really matter, because I’ve got others. Here’s a less famous, more verifiable quote:
“Compound Interest is a Magic Unicorn of Awesomeness.” – This Guy
I think I like that one better – no offense fake-Einstein. It’s true: compound interest is a form of magic. It’s certainly the only force in the universe that can turn 10% of your paycheck per year into enough money to retire on. Relativity isn’t helping you with that one.
But there’s a dark side to compound interest, the anti-matter to compound interest’s matter. Unfortunately, even as compound interest lifts your investment portfolio to dizzying highs, it’s simultaneously in the shadows helping your broker get rich off of you. Sadly, math does not discriminate. Compounding works on investment fees the same way it works on investment gains.
What are investment fees? Well, when you buy a stock, you generally pay a one-time fee to buy or sell that stock. But when you invest in ETFs or mutual funds, which are the backbone of most 401(k)’s and other retirement accounts, you are paying a yearly expense ratio. These expense ratios, sometimes called ER’s, are a percentage of your total account, taken each year. They range from .04% of funds on passive index trackers to upwards of 2% or higher on actively managed accounts.
These numbers look so tiny compared to the stock market’s normal swings as to seem almost adorable. But they add up. As your account grows over time, the total amount of the fees paid grows as well.
Why am I depressing you with this? It’s to try to convince you that fees matter. Of course we can’t eliminate fees – investment firms need some money to keep the lights on. But we should shop around for low investment fees no differently than we shop for the cheapest gasoline or toothpaste. By focusing on low fee investments, we can blunt the forces compounding against us.
Let’s look at two investment scenarios: one with a 1% expense ratio and another with a .1% expense ratio. Both of these are common fee amounts in the mutual fund world. We’ll say that we’re investing $10,000 per year and assuming 8% yearly investment gains. Of course real life is messier; your accounts will seesaw up and down over the long term. But 8% is a good guess based on historical stock market returns; conservative, even. It’s good enough for our purposes.
First, for comparison purposes, let’s look at the growth of our money over twenty years with no fees at all:
Account with no fees.
That’s pretty impressive. We have nearly half a million dollars, all due to the magic of compound interest! Is it enough to retire on? Probably not, unless you have some other income streams. But it’s a great start. Now, what if we introduced just a 1% yearly fee into this rosy investment picture?
Cumulative Fees (Expense Ratio 1.0%)
1% Fees over Twenty Years
Wow! Over twenty years, we’ll pay over $30,000 to investment companies if we let them take 1%. Notice that our ending balance is actually nearly $60,000 less than our “no fee” example. That’s twice as much as the fees actually took. Where did the extra money go? How could this be?
This is the biggest reason that fees matter. They hurt you in two separate ways: they’re taking your money and they’re reducing your balance, giving you less money to compound and grow. If compound interest is a snowball rolling down a hill and growing exponentially, the fees are rocks and dirt that both knock existing snow off and prevent new snow from sticking.
What about a .1% fee? This is fairly common in passive index funds offered by big investment houses, low but not the lowest out there. It’s smaller than 1% for sure, but both numbers are pretty small. Does it make a difference? Take a look and see:
Cumulative Fees (Expense Ratio .1%)
.1% Fees over Twenty Years
What?!? Not only are the fees nearly ten times less than in the previous example, but our final balance is almost the same as if there were no fees at all. A lower fee helps you in two ways: it takes less from your pockets and it blunts your compounding interest less. You can think of your investments like a rocket trying to escape the earth’s atmosphere. With .1% fees, it gets into space without much fuss. But at 1% and above, it just keeps getting dragged back down to earth.
So now we’ve seen that when it comes to compounding fees, some are more evil than others. That $60,000 of extra fees could mean a year or two of retirement expenses, and the lack of that $60,000 could mean delaying retirement or having to go back to work. The $3,600 lost to the lower fee investment is not going to influence anyone’s retirement decisions.
What’s the takeaway? Remember: fees matter because they hurt you in two ways. Find the lowest fees you can. And whether good or evil, compound interest is still a magical unicorn of awesomeness, whether or not Einstein ever said so.