[Editor's Note: The following is one of my regular columns published at Forbes and is about a frequent topic on this site — how to lower your investment-related costs for maximum returns.]
Limiting your investment-related fees and expenses is a critical aspect of investing. In my work at The White Coat Investor helping doctors, attorneys and similar high-income professionals develop financial literacy, I have repeatedly seen that most investors are paying far too much in investing expenses. Reducing these is one of the most reliable ways to boost your return without taking on any additional risk. Unlike many things in life, with investing, you get (to keep) what you don't pay for.
Reducing investment costs could potentially allow you to retire years earlier with far more money. Consider two investors, one of whom is paying 2% of the portfolio each year in investment related expenses and 1% of the portfolio in taxes (3% total) to an investor paying 0.1% in expenses and 0.4% in taxes (0.5% total). If we assume they both invest $50,000 per year for 30 years and earn 8% before fees, how much less will the investor with the high expenses retire with? A quick calculation shows that she will end up with 37% less ($5.6 million vs $3.5 million.) As the investor moves into her retirement years, those high expenses continue to limit the amount she can spend from the portfolio and make it far more likely that she will run out of money.
It is critical that an investor examine each of these five categories of expenses and minimize them wherever possible.
5 Investment Related Expenses to Minimize
# 1 Advisory/Management Fees
Perhaps the largest category of expenses are those paid for financial advice and investment management services. Many in the industry consider 1% to be a standard level of fees. However, on a multi-million dollar portfolio, 1% can add up to $20,000, $50,000 or more each year for the exact same work the investor used to pay $5,000 for. When paying an advisor an Asset Under Management (AUM) fee, it is critical to do the math each year by multiplying the portfolio size by the fee.
Since there are many high-quality advisors willing to provide these services for $1,000 to $10,000 per year, it seems silly to pay $50,000. A better arrangement (for the investor at least) is to pay either a flat annual fee for investment management and/or an hourly rate for financial planning. Although your fees will still likely add up to a four-figure amount each year, at least they will not be a five figure amount.
Recognizing the importance of costs, some interested investors have decided to educate themselves about investing. With time, the necessary knowledge and discipline are relatively easy to obtain, but the potential do-it-yourself investor should be cautioned that they would be much better off paying a fair price for good advice than doing it poorly themselves. Of course, there are hybrid solutions that can reduce fees dramatically. These include enlisting the aid of a financial planner with the initial development and implementation of a plan and then maintaining it yourself. One could also meet with an hourly rate advisor periodically for a second opinion and a sounding board on any changes to their plan.# 2 Mutual Fund Expense Ratios
Another significant fee for most investors are the expenses associated with running the mutual funds they invest in. Yet again the industry seems to believe that 1% is the industry standard. However, using low-cost index funds from providers such as Vanguard, Fidelity, iShares, and Charles Schwab you can relatively easily reduce that cost to less than 0.1% per year. Every dollar saved is a dollar that remains in your portfolio working for you.
Some beginning investors might wonder if paying cut-rate prices gives them cut-rate returns. However, time and time again its demonstrated that over the long run low-cost index funds outperform the vast majority of their actively managed peers. In fact, having low costs is one of the best predictors of future returns of mutual funds. It certainly works better than looking at past returns, the method most investors use. It isn't that the managers are stupid. On the contrary, the issue is that they are all so smart that they make the market efficient enough that the game of trying to beat it is no longer worth playing. They can add value, but not enough to overcome the cost of playing, especially once taxes are taken into consideration.
# 3 Commissions
Investing-related commissions are an interesting expense to consider. These can be completely eliminated by a do-it-yourself mutual fund investor who buys funds directly from the fund provider. However, many investors are paying huge amounts in commissions. This is often a result of mistaking a commissioned salesman for a fiduciary, fee-only financial advisor. While they think they are being given unbiased investment advice, they are actually being sold high-expense mutual funds and insurance products such as annuities and whole life insurance by a broker operating under the suitability standard rather than the fiduciary standard. At times these salesmen may obscure the fact that they are charging commissions by calling them “loads” or even telling the investor that the insurance company is paying that cost, not you. Of course, all expenses are ultimately paid by the investor.
Even a do-it-yourself investor may be running up the commission bill. A commission may be charged each time an individual stock or ETF is bought or sold, even inside a qualified retirement plan like a 401(k). Even at a rock-bottom price of five dollars per transaction, if you're doing 20 transactions a month it adds up to $1,200 per year. While you don't necessarily want the expense tail to wag the investment dog, every little bit helps keep costs down and returns up.
# 4 Turnover-Related Costs
Wise mutual fund investors always look at the turnover percentage when selecting a fund. Embedded in that percentage are some hidden expenses paid by the fund but may not be included in the expense ratio. Costs include commissions paid by the fund and bid-ask spreads that allow the market-maker to cover her own expenses and profits. A broadly-diversified index fund may have a percentage less than 10% (meaning less than 10% of the stocks in the fund are bought or sold each year) while an actively managed mutual fund may see a turnover percentage of 200% or more. A long-term, buy-and-hold investing philosophy on the part of the fund and the investor helps keep these costs down. A speculating day-trader is continually whittling down the nest egg with each transaction.
# 5 Taxes
Taxes are another major expense borne by the investor. Although this expense helps pay for government rather than the financial services industry, it lowers the investor's return all the same. There are many techniques for lowering these costs, and a good advisor or do-it-yourself investor should be familiar with most of them. Investing in tax-advantaged accounts such as 401(k)s, Roth IRAs, Health Savings Accounts, and 529 College Savings Accounts makes a big difference. So does limiting turnover by lowering capital gains taxes due, particularly short term capital gains taxes. More advanced techniques include tax loss harvesting, tax gain harvesting, using appreciated shares for charitable donations, use of municipal bonds when bonds are held in a non-qualified account and appropriate tax location of asset classes.
Lowering your investment-related expenses are a sure-fire way to boost your returns, hasten your retirement and allow for a more comfortable retirement without taking on additional risk. Do all you can to reduce your advisory fees, mutual fund expenses, commissions, turnover-related costs, and taxes.
What have you done to lower your investment-related costs? Comment below!
Morningstar’s 2019 Target Date Fund Report is out and I was pleased to see Expense Ratios of 0.6% are considered expensive and the money is moving to funds with ER less than 0.2%. This will make a huge difference for the vast majority of people who want to keep it simple in their 401k with a target date fund, and hits all 5 of your points above.
CITs (Collective Investment Trusts) rather than mutual funds are being used in a majority of target date funds. Anything White Coat Investors need to understand about CITs?
https://www.morningstar.com/blog/2019/05/09/target-date-fund.html?con=10355
Harry Sit covered it well years ago: https://thefinancebuff.com/collective-trust-vs-mutual-fund-whats-the-difference.html
The moment I realized I was duped by a financial advisor when I was in residency and put in front loaded mutual funds was the light bulb moment when I decided to learn finance myself, sell those funds and put them in index funds.
Not only did I have to pay something like a 5% front load but I also had higher expense ratio in these funds that was slowly bleeding away my portfolio. It also makes it difficult to know whether or not the financial advice was biased/self serving because of the commission potential. Luckily the money that was in play is now relatively small but it was a big deal at the time. It also used up valuable Roth space that I had when I invested in that account.
From the late, great, John C. Bogle’s 10th Anniversary Edition of THE LITTLE BOOK OF COMMON SENSE INVESTING:
“As Morningstar suggests, if investors could rely on only a single factor to select future superior performers and to avoid future inferior performers, that factor would be fund costs. The Record could hardly be clearer: The more the managers and brokers take, the less the investors make.” (62)
Good advice with a fiduciary advisor is worth something, especially for those who don’t want to become a do-it-yourself financial planner and investor. But the price needs to be fair and the advice independent and prudent.
I have been DIYing for some time, in the last year I have seen my portfolio go up a lot and my thinking was once you reach a critical mass and if your costs are low, it takes off. My portfolio grew really slowly till it reached around 1.6 to 1.8M. After 2M I started seeing a lot bigger jumps. I am upto 2.3M right now. I am hoping when I reach 4 to 5 M my jumps or falls would be crazy.
I already have made more this year than my entire years salary worth!
Its all true, indexing and low cost add up finally.
It’s fun to feel that snowball effect. Of course, like leverage, it goes both ways.
With one job I had, the investments in a tax-advantaged account had fairly high expense ratios. The match wasn’t too stellar, either. I think I recall some colleagues bemoaning these facts (the match especially–expense ratios were too “in the weeds”) and simply opting out of using this investment space entirely.
If one has no control over some of the factors you list above, I think it still goes without saying its better to have $3.5 million (to use your opening example) than nothing at all! The way I personally handled this issue was continuing contributions in that account, opening a roth, and building up a taxable account with #1-5 in mind.