Hypothetically, if an investing book with 30 chapters were rightly ordered, the first 29 of those chapters could quite literally be on the importance of keeping fees low. I realize that message gets a little bit old and tiresome, which is why it’s important for us in the financial industry to keep finding creative and interesting ways to say the same thing: “KEEP YOUR FEES LOW!”
Seriously, should you retain nothing else from any of our blog posts aside from that message, Marko, Ryan and I would all consider that a win. Keep your fees low. Drop the mic; walk off stage. You’re done. You can stop reading here (though you really don’t have to). If you can do just this much consistently over time, you win.
Let’s talk about why keeping fees low is so important.
The Most Powerful Force in the Universe
What do you think is the most powerful force in the universe? Maybe you think it’s gravity (a good guess), or perhaps your need for a strong cup of coffee first thing in the morning (another pretty good guess). However, in our minds, the most powerful force in the universe is compound interest. If this idea sounds familiar to you, it’s because this idea is frequently attributed to Albert Einstein (though whether or not he actually said this is questionable).
Let’s do a little math. Say you took $100 and invested it in the market with a 7-percent annual return. At the end of the first year, you have $107. At the end of the second year, you’ve accumulated $114.49. Extended out 10 years, that initial investment would come to $196.72. In this thought experiment, assuming relatively reasonable returns, you’ve almost doubled your investment after 10 years. Nice work!
Now, let’s introduce fees into the equation. Let’s use the same parameters, same principal, same returns, but this time let’s say you’re paying a 1 percent fee at the beginning of each year. At the end of the first year, you have $106.93—well, that’s not so bad. But at the end of the second year, your total is $113.17, over a full dollar behind your fee-free investment. Extended out 10 years, your initial investment would turn into $177.91, about a full $20 back from the fee-free investments.
Simplicity and Evidence
Now, the above example is obviously a pretty large simplification of a very complex topic. There are very few investments that are absent of any overhead at all, and there are other good reasons that low fees are important (namely that low fees typically imply a simplistic, well-diversified investing strategy). However, it’s a good illustration of how even small fees can drag down your returns by a huge amount over time. In a similar article regarding keeping fees low, CNN Money expert Walter Updegrave writes,
“The results you’ll get will vary depending on how much of your saving you do through a 401(k), what your plan’s expenses are and how diligently you stick to low-cost investment options both within and outside your 401(k). Nor is it a given that lowering expenses will translate dollar for dollar into higher returns. Some funds may be able to justify their higher expenses with outsize gains. Still, to the extent that you can stick to lower-cost investments, you should be able to build a larger nest egg during your career and draw more from it in retirement than you would with investments charging higher fees.”
Further, A Morningstar study found that low fees were a better indicator of a fund’s future net returns than their star rating:
“Overall, expense ratios outdid stars in 23 out of 40 (58%) observations… Perhaps the most compelling argument for expenses is that they worked every time–because costs always are deducted from returns regardless of the market environment. The star rating, as a reflection of past risk-adjusted performance, is more time-period dependent. When the market swings dramatically, the star rating is going to be less effective.”
One of our guiding principles is, “The more the system takes, the less the investor makes.” And that’s something we’ve always stood behind because it’s backed up by the evidence.
The Number One Rule
Over the next few posts, I’ll be discussing some of the more complex topics in investing: things like asset allocation, risk and investor behavior. No matter how much you’re able to follow along with those topics, I hope you’ll keep in mind the number one rule of investing: KEEP YOUR FEES LOW!
Vern Cushenbery is a partner and CIO of Two West Companies and a great lover of graphs, charts and looking at long-term trends in the market. This year, he gave up being tired for Lent, committing to getting at least seven hours of sleep every night.