A lot of investors believe that a reasonable percentage (i.e., 1%) of their investments is not a lot of money. And because they don’t have to write a check for the fees (they are automatically taken out of your investment account), they may never feel the true effect of this cost. They consider the fees as the “going rate”…just a part of doing business.
But the fees are real. Oh, they’re very real.
Here is a typical investment fee structure for millions of Americans:
- They have $350,000 invested in mutual funds.
- On average, the mutual funds earn 8.5%, or $29,750 per year.
- Their advisor charges 1.25% per year on the $350,000 ($4,375), and the mutual fund companies charge you 0.85% per year on the $350,000 ($2,975). The total combined fees per year are $7,350.
But the client doesn’t calculate the true amount — $7,350; they just believe a percentage under management fee is normal and obviously worth the price.
Now, let’s consider three alternative ways to look at this $7,350 in fees.
- First, let’s look at these fees as a percentage of your investment returns. Under this scenario, each year you’re paying your investment advisory firm 24.7% ($7,350 fees / $29,750 returns) of your returns. So, you’re the one taking all the risk, and they’re getting nearly 25% of the returns? Is that fair? Are financial advisors really that skillful at selecting mutual funds? According to studies, they are not. Over the long haul, Index funds, which require no selection skill whatsoever, beat actively managed mutual funds 83.7% of the time according to a recent study.
- Second, let’s look at these fees as a percentage of your disposable income. (This is the big one!) Let’s say your income is $120,000 per year, leaving you disposable income of about $84,000 per year. Your investment fees are a whopping 8.75% ($7,350/$84,000) of your disposable income! Wow! That percentage could be your annual rent for an apartment, a mortgage payment for the year, an amazing vacation each year, or LOTs of savings!
- Third, let’s look at these fees as if instead of paying them, you keep the money in your nest egg. Over 25 years, if you saved $7,350 each year earning 8.5%, you’d have $578,977 in your savings…more than half a million dollars! Realistically, the amount is even greater because I assumed your $350,000 doesn’t grow, and therefore the $7,350 in fees doesn’t grow. The financial damage is actually much worse.
It’s no wonder investment firms can pay their employees hundreds of thousands of dollars per year (and their executives millions), rent the most expensive real estate in big cities, pay for the most expensive TV commercials, and possess 30%+ operating profit margins. For the investment firms, this is a terrific business model. But you may end up on the wrong side of that business model — sorry!
My point is that if you pay an advisor a percentage of assets under management and also pay the mutual funds companies to invest, you should seriously consider whether or not you’re truly getting a return on your investment. Is the advice they’re providing worth all the money you’re paying? Are their ideas worth half a million dollars? If they aren’t, what are your alternatives? I’ll address that question in my next blog post later this week.
The truth is that getting financial advice should cost you money — but the relationship should not be a partnership where you take all the risk and advisors always get paid. Because if it truly were a partnership, the advisers would lose principal when the stock market falls, but they don’t — they just keep charging you the 1.25% in fees.
Feel free to check out Tilly’s Free Guide to learn more about how to invest.