Dropping the Hammer – why investment fees matter so much.

OK, I’ve hinted at this in past posts – time to bring the big evidence to the party.  Over-paying for fees (12b1 fees, active management fees, custodial costs, etc. etc. – anything that takes away from your potential return) has a massive impact on your accumulated savings.  Just how large will shock many.  It was on the front page of the WSJ last weekend, but I bet many missed this key nugget of info.

The cause of any surprise has its roots in the mathematical capacity of our brains.  Firstly, we like to think intuitively – fast thinking which hates math.  Secondly, higher order concepts like continuous compounding are stretching what we can understand.  Fractal or Mandelbrotian Geometry?  Beyond me, yet is said to be the best descriptor of what is going on in financial markets.  Unfortunately, our brains do have limits.  (and I am not going to spend my weekend giving myself a headache reading Fractal Geometry – I have more fun ways to give myself a headache!)

So, Joe Average is paying 1% too much in fees.  Getting 5.5% instead of 6.5% on his investments (starts with $25,000 and no additions/subtractions for 35 years).  Not a big deal, right?  Getting 85% of the 6.5% return, right? (5.5/6.5 = 85%). This does not translate into 85% of  what a 6.5% investor will accumulate over his/her lifetime.  Instead, a 5.5% investor ends up with only $163,000 of accumulated savings vs a 6.5% investor who ends up with $227,000. (source: Dept of labor, WSJ)  Huge deal!  In this case, $64,000 in forgone savings.  39% of your nest-egg eaten by a measly 1% mistake.

Why is this?  What most people miss, is that a 1% error in one year compounds every single year for the rest of your life.  If you make the same mistake again in year 2, that too will compound out over your remaining investing horizon.  Keep at it, and the compounding of errors really pile up, and you end up with a much smaller nest-egg than your intuition would have you believe.  And this is not debatable – this is math.  Like the CREE add on TV says……”if you argue with mathematics………you will lose.”  Your nest-egg will follow the rules of math whether you want to believe them or not.

So there you have it – small mistakes on fees compound to leave you with a lot less spending power than you might have guessed.  What the brain tends to miss is the continuing nature of a small mistake.  The knock-on effects (compounding) are difficult to visualize, so we tend to miss them.

No need to worry, you can change your behavior immediately after reading this post. However, the longer you delay, the smaller is the benefit of the change you will be making.  This too is continuous compounding in action.