Imagine top scientists engaged in a serious discussion about whether the Earth is round or the moon is made of cheese. Silly, right? Now imagine investing professionals engaged in a serious discussion about whether investment advisory fees of 1.5 percent plus $750 a year on a $450,000 portfolio are too high. That's exactly what I encountered in the Q&A section of BrightScope.com, a 401(k) ratings firm.
Some quick math tells us that the investor paying these fees is shelling out $7,500 a year. These costs don't account for the underlying cost of the investments. Over a ten-year period, and assuming an 8 percent return would have been earned had these fees stayed in the account, this investor will lose nearly $110,000, or almost 25 percent of the starting balance in the portfolio.
Over 20 years the loss triples to more than $340,000. Over a 40-year period the loss is seven figures. And these figures assume a constant fee of $7,500 a year, not an increasing fee that would come with a larger portfolio.
It's time to get real. High investment costs will wreck a portfolio. Here are five costs that are the most pernicious:
Advisory fees. Paying an investment advisor 1 percent or more annually almost guarantees below-market performance. Even the most talented advisors, over the long run, are unable to beat the markets by the cost of their services.
For those looking for investment help, there are several lower cost alternatives. First, a low cost mutual fund company like Vanguard offers investors advice on constructing a diversified portfolio. Second, there are low cost and easy to use online tools that make investing a snap. For those considering a traditional fee-only advisor, forget paying 1 percent. While that may be the standard cost, there are plenty of advisors that charge 0.5 percent or less.
Management fees. Mutual fund fees also eat away at a retirement portfolio. Low cost index funds typically carry an expense ratio of 10 to 25 basis points. Actively managed funds can easily cost 100 basis points or more. Studies have shown that actively managed funds rarely beat the market over the long run. It's also impossible to predict which funds, if any, will beat the market in the future.
Transaction costs. The expense ratio does not include a mutual fund's cost to buy and sell shares. For actively managed funds, these transaction costs can be significant. John Bogle, the founder of Vanguard, estimates that transaction costs add an additional 50 basis points in costs to actively managed funds.
Commissions. While fee-only advisors do not earn commissions on the investment products they sell, commissioned brokers do. These fees typically amount to more than 5 percent of the amount invested. Commissions are in addition to the management fees charged by the mutual funds.
Unnecessary taxes. Actively managed funds often generate significant tax liability. While these taxes are of no concern in a tax-advantaged retirement account, they can represent a significant drag on performance in a taxable account. In contrast, index funds typically do far less buying and selling. The result is less taxable income and lower transaction costs.
Rob Berger is an attorney and founder of the popular personal finance and investing blog, doughroller.net. He is also the editor of the Dough Roller Weekly Newsletter, a free newsletter covering all aspects of personal finance and investing, and the Dough Roller Money Podcast.
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