After you take into account commissions, management costs and cryptic sounding stuff like 12b-1 fees, every dollar that you save and invest is more like 98 cents working for your future.
A couple of pennies falling through the cracks may not sound like much, but remember: Every penny you sacrifice in fees is a penny that’s not able to compound and grow over time.
- Let’s say you invest $25,000, earn a 7% average annual return on your investment, and pay a reasonable 0.5% in fees. After 35 years that pile of pennies will be worth $227,000.
- Now, what happens if instead of 0.5% in fees, you pay 1.5% -- a mere percentage point more? Say Sayonara to $64,000. That’s how much fees stunt the growth of your portfolio over time. And in this scenario paying 1.5% on your $25,000 investment gets you only $163,000 after 35 years.
When it comes to fees, compounding is working against you: Instead small amounts of money growing over time in your favor, it’s small fees compounding into massive costs. (Just in case you need a little more convincing: Are You Using Compound Interest For Good or Evil?)
Keep An Eye Out for Fee Creep
Ideally, investing fees should gobble up no more than 1% of your overall portfolio value. These days with so many low-cost investing options, that’s an easy guideline to stick to -- at least you’d think it would be.
When it comes to managing money, everyone wants a piece of the action -- brokerages, fund companies, retirement plan administrators, advisors, planners, Uncle Sam. Investors need to guard the most vulnerable areas of their portfolio from being attacked by a fee feeding frenzy. (How much are you paying in fees? Find out with a free portfolio analysis.)
Make sure all of your dollars are building your wealth by keeping a close eye on these six costs.
1. Workplace Retirement Plan Fees:
Employer-sponsored retirement plans (401(k)s, 403(b)s) have a lot going for them, including tax-saving features, automated investing, and potentially a company match on a portion of what you invest. Of course, setting up and providing ongoing administrative support isn’t free. And the fund companies within the plan want their cut, too.
On average, 401(k) fees range from 1% to 2% [AmericanProgress.org: http://ampr.gs/1PpWRnt]. And who picks up the tab? In most cases those costs are passed right along to you and other participants in the plan. While even a mere 1% might not sound like much, when that amount is skimmed off the top of your ever-growing account, the financial blow packs a massive wallop -- especially in these accounts where the bulk of most people’s retirement money is saved.
2. Trading Commissions:
When it comes to taking investing into your own hands, basic administrative fees such as trading commissions are one of the easiest fees to spot before things get out of hand.
If you invest in individual stocks or buy mutual funds through a brokerage, you can check the cost of trading (buying and selling) by looking at the brokerage’s fee schedule. Many brokerages charge a flat fee to place an order (e.g. $4 to $10 for stock trades; $20 to $50 or more to buy a mutual fund (unless the fund company is part of the broker’s network). But fees for things like options trading, broker-assisted trades, REITs and other types of investments can be much more. And don’t forget about other costs you may have to cover -- transfer fees, account closing fees, and extra costs if you want to have a human being make your trade.
That said, even if you only have a small amount to invest, don’t let the cost of a few brokerage commissions thwart you. Get that money to work for your future ASAP. (See: Here’s Why You Should Start Investing Now.)
3. Mutual Fund Management Fees
The administrative costs of investing in stocks via a brokerage pale in comparison to the charges generated within actual investment products, especially mutual funds.
It’s not cheap to assemble, market, manage and administer a mutual fund. There are fund manager and staff salaries to pay, slick commercials and marketing materials to produce, and thousands of trades (and associated commissions) to make within the fund. The sum of these costs is expressed as a fund’s expense ratio.
You won’t find the expense ratio itemized on your account statement: You have to look it up on the mutual fund’s prospectus (or on a site like Morningstar.com). After you find the number, you can probably guess who pays the tab -- yup, that investor whose mug you’re staring at in the reflection of your computer screen. Fund fees are deducted automatically from the mutual fund which, of course, reduces the fund’s overall returns -- your returns.
fee study by mutual fund tracker Morningstar. Remember, that’s 1.19% in returns that the mutual fund pockets, not you. [Morningstar: http://bit.ly/1jkB051]
FutureAdvisor actively avoids investments with excessive fees, and uses index mutual funds, ETFs or other financial instruments with very low expense ratios -- typically 0.025% to 0.15% of the amount you invest.
4. Bid-Ask Spread:
Besides commissions, investors also pay what’s called a “spread” when they buy or sell stocks or mutual funds. This cost is one that is often overlooked by investors -- but it should definitely be on your radar. When you look up the price of a fund or stock and you see it’s $20 per share (that’s the “bid”). But the price you have to pay if you want to buy the share (the “ask”) is always a little higher (say, $20.50, in our example). The difference between the two is the bid-ask spread and every buyer -- including giant mutual funds -- must pay it.
Given the size and number of the trades mutual funds make, the bid-ask spread may result in additional costs for mutual fund shareholders. These costs may be minimized by avoiding funds with a high-turnover rate (a.k.a. heavy trading activity) which may generate higher total trading costs.
5. Liquidity Costs:
You’ve heard of a “buyer’s market” or a “seller’s market” referring to real estate. The same concept is at play in the stock market, too. Investors can only buy or sell a stock or mutual fund if someone else is willing to sell or buy their shares. So when a fund has low liquidity -- also called low trading volume because there’s not a lot of buying and selling going on -- investors have a harder time fulfilling their trades in a timely and cost-effective manner. If a fund’s price drops and a lot of investors decide to withdraw their money at once, those who weren’t able to get out early are going to be left trying to sell shares at fire-sale prices.
Typically you’ll see low liquidity in newer funds and ones that don’t have a lot of assets under management. It behooves investors to check a fund’s liquidity because it has a direct effect on the bid-ask spread and can make it expensive to build a portfolio.
At FutureAdvisor we only select funds that have been around for a sufficient amount of time and have significant assets in the funds and good daily trading volume (high liquidity).
6. Tax Cost Ratio:
Lastly, we end with a word about taxes. Obviously, you want to keep tax costs down as much as possible. But in some situations you have little control. When a mutual fund distributes dividends (from stocks or bonds within the fund), and capital gains to shareholders, that counts as income and gets Uncle Sam’s attention. It doesn’t matter if the distributions are paid out in cash or reinvested to purchase additional shares: Investors are required to pay taxes on that income for the year in which it was received.
The “tax cost ratio” can vary depending on how much buying and selling is done within the fund. According to Morningstar, fund tax cost ratios fall somewhere between 0 (the fund generated no taxable distributions) and 5 (indicating a less tax-efficient fund). Each percent you pay in taxes lowers your return on an after-tax basis. (Note: If you hold the fund in a tax-deferred account (like a 401(k) or Traditional IRA), you’re off the hook for taxes until you start making withdrawals.) [Morningstar: http://bit.ly/1G1r5ey]
It behooves investors who are considering buying or selling in a taxable account to beware of funds that have a high turnover rate (generating more frequent taxable events). Also, watch your timing: Avoid buying a fund right before it pays out a distribution (which typically occurs at the end of the year). Otherwise you’ll end up buying yourself a tax bill on investments that you didn’t even get the chance to profit from.
See How Fees Are Affecting Your Returns
Don’t spend one more dollar on unnecessary fees. Get a free detailed screen of your current investments (including the ones in your 401(k)). We’ll point out any fee funny business and recommend low-cost, tax-efficient, diversified mutual funds and ETFs to replace any fee-laden ones that you currently own.