One-percent is such small number. Many people (but sadly not most people) could afford to put 1% down on a home. Differences of 1% are normally rounded off and seen as insignificant in most engineering analyses. So why would it matter if your mutual funds were charging you 1.5% fees versus 0.5% fees each year? After all, it’s just a 1% difference, right?
Over long periods of time, a 1% lower return each year will make a huge difference. If you invest $200 per month in bonds, assuming a 7.5% average return over a career, you’ll end up with $200,000 more if you pay 0.5% versus paying 1.5%. Stocks are far worse. Over a career, investing the same $200 and assuming a 12.5% average return, you’ll miss out on $1.3 million if you pay an extra 1%! One point three million dollars just due to a 1% higher fee.
The table below gives the value of both a bond and stock account that is charged a 0.5% and 1.5% fee after 20, 30, 40, and 45 years. Note that managed funds will typically charge fees in the 1-1.5% range, while unmanaged index fund and ETF fees will be in the 0.5% range or less (I think the Vanguard S&P500 fund charges something like 0.15%!). All analyses are assuming a $200 monthly contribution and a 7.5% return for bonds and 12.5% return for stocks before fees.
Bonds Stocks
Years 0.5% fees 1.5% fees 0.5% fees 1.5% fees
20 $92,400 $104,000 $173,000 $198,000
30 $201,000 $244,000 $561,000 $699,000
40 $398,000 $525,000 $1,720,000 $2,350,000
45 $551,000 $759,000 $2,990,000 $4,290,000
Note a couple of things. First notice that after about 20 years, you’ll have twice as much investing in bonds than you’ll have investing in stocks. In thirty years that ratio will grow to almost three times. In 45 years, you’ll have six times as much by investing in stocks. The stock portfolio will provide a comfortable retirement, while the bond portfolio will not be quite enough to feel truly secure. This is why you want to invest in stocks when you are investing for a long period of time because the long-term returns are so much better.
The second thing to notice is the huge amount that you’ll give up due to the higher fees in both the stock and bond portfolios. Over a working lifetime, you’ll have about a quarter of a million dollars less in your bond portfolio with a 1.5% fee as you’ll have with a 0.5% fee. In the stock portfolio, you’re giving up more than a million dollars. Perhaps the worst part about paying higher fees is that you lose the ability for a portion of your portfolio to compound because you’re paying it out in fees. Not only do you pay the fees – you lose the interest on the fees, and the interest on the interest.
Of course, the main reason people invest in managed funds and pay the higher fees needed for research, trading, and the fancy offices in which the mutual fund managers reside is that, theoretically, they make a higher return due to their adept trading than that which would be produced in an unmanaged index fund. The trouble is, however, because they have to buy so many different stocks, because they have so much money to invest, they basically just end up “buying the market” anyway. As a result, managed funds typically do worse than unmanaged funds over long periods of time because they get the same returns as the unmanaged funds, yet their fees are higher.
So, if you’re looking for investments in your 401k, it would be wise to choose unmanaged index funds and buy the funds with the lowest fees. If you have the choice between a large cap stock fund with a 1% fee and an S&P500 index fund with a 0.25% fee, go for the index fund. When adding mutual funds to your taxable portfolio or your IRA, consider index funds through a provider like Vanguard or ETFs on those index funds. If you think that a particular manager will be able to outperform the markets over the long-term, maybe put a portion of your investment portfolio in their fund, but I’d still hedge my bets with an index fund.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.