How to Minimize Your Investment Costs

In my last 2 blog posts, I discussed the various ways financial advisors can be paid and how they can present conflicts of interest to an advisor. But how would your actual investment returns be affected? Let’s take a look at some scenarios:

Buying a mutual with an upfront load. In scenario #1, you invest $20k in a mutual fund through an advisor selling them for a commission. Let’s say you pay a 5.75% upfront load (called an “A” share).  After the $1,150 load, you would have $18,850 invested in the fund. If it grew at an average 7% a year, it would be worth $102,307 after 25 years.

Asset Management Fee. In scenario #2, you invest $20k in a mutual fund through a fee only advisor and pay a 1% asset management fee every year. Your entire $20k gets invested upfront but you only earn 6% a year after the management fee. After 25 years, your investment is only worth $85,837.

Flat fee. In scenario #3, you invest $20k and pay an hourly $300 fee to have an advisor help you select the fund. If we subtract that $450 from the $20k investment, your $19,550 would grow to $106,920 after 25 years, assuming the same 7% average rate of return.

So what’s the lesson here? All things being equal, an upfront fee is less than an ongoing fee in the long run and a flat fee usually comes out to be even less. The problem is that the flat fee stings more because you see it in dollar terms (and sometimes even have to write a check for it) while the load and asset management fees look like smaller numbers (until you do the math) and they’re always deducted from your account so they’re less visible.

Of course, that all assumes that all else is equal and that the investments have the same return before fees. The advantage of the fee only advisor is that they have more funds they can recommend because they’re not limited to load funds. However, there’s no evidence that advisors are actually successful in picking winning funds.

Studies have shown that your best bet is to go with low cost index funds rather than paying an advisor to pick funds for you. If you don’t need more comprehensive financial planning advice, you can go to a discount brokerage firm like Charles Schwab, Fidelity, TD Ameritrade, Scottrade, or Vanguard and purchase low cost index funds without any loads or advisory fees at all. They also have representatives who can help you select index funds to make sure your portfolio is properly diversified. While some may try to talk you into signing up for an advisory service where you pay a fee for ongoing advice or management, you can generally get one-time advice at no cost. Fortunately, index funds are low maintenance and just need to be periodically rebalanced so you really don’t need to hire an investment advisor to manage them.

So to minimize your investment costs, remember these five rules:

1) When it comes to investing, you get what you don’t pay for. Never ignore fees and trading costs.

2) Do the math. Ongoing fees usually cost more in the long run than one-time upfront fees.

3) Don’t forget that the cost of the fund can be more than the cost of the advisor. Index funds are particularly cheap and have been shown to outperform the vast majority of actively managed funds over time.

4) Index funds just need to be rebalanced periodically. You don’t need to pay someone to “manage” them.

5) Consider discount brokers if you’re just looking for help putting together your portfolio. They can often help you select low cost investments like index funds without additional fees.

 

 

 

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