Investors tend to look at past returns when making investment decisions but pay no attention to fees charged by these funds, which typically proves to be a very costly error for the investor. A second mistake is to focus on highly hyped stocks and other investment vehicles that are “too hot to pass up.” I write more about the psychology of investing in “Emotional Traps of Financial Investing.”
According to the U.S. Department of Labor, American investors pay $17 billion in fees on an annual basis, but what does that mean for the average investor?
The Impact of fees on investments starting with $100,000: Assuming an 8% annual return, a Mid-Cap Exchange Traded Fund (ETF) with a 0.09% expense ratio would total $458,388 after 20 years. The same portfolio of holdings in a Mid-Cap Actively Managed Class A investment with a 5% commission upfront and 1.36% annual expense ratio would total only $343,658 at 20 years.
So what did the second investor reap for paying the higher fees? They’re in the hole $100,000 compared to the low-cost Mid-CAP ETF investor!
The graph Fees are killing your retirement from “The Crushingly Expensive Mistake Killing Your Retirement” in The Atlantic magazine provides an equally powerful illustration of the impact of fees on the individual investor. This example assumes that two 25-year-olds begin funding their 401(k) with $3,000 per year. One selects a low cost index fund (0.08% fee) while the other selects a managed stock fund (1.33% fee). When ready to retire at age 65, the index fund is worth nearly $600,000—assuming an average 7% rate of return, while the managed stock fund is worth about $430,000, also assuming 7% growth. So what is that young investor’s reward for selecting the actively managed fund: a deficit of about $160,000!
That’s the cost of the additional 1.25% fee compounded annually for 40 years!
In general, passive investment with lower fees pay much more over time than actively managed investments with higher fees. In my next post in this series on “Stacking Fees, the New Pyramid Scheme,” I’ll review a very popular investment vehicle with outrageous fees and commissions: the Variable Annuity.
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