The dark side of the compounding force

2015-08-25 07:29

The clever will talk about the power of compound returns, but the truly sophisticated will realise that as sure as compound returns help to grow your wealth over time, so unnecessary costs will do the exact opposite.

In my reference to spending less than you earn, I challenged you not to focus too much on ‘spending less’, but rather to try and ‘earn more’. This turned the wealth equation on its head, such that life didn’t become a race to the bottom for the cheapest cost of living, but rather a situation in which you value ‘brand you’ and work your ability to earn an income, with the ultimate goal of having enough to live the life you really want.

As nice as it was to feel in charge of your own wealth equation, the options are slightly more limited when it comes to your investment returns.

You can’t control the market.

When it comes to investment returns on your wealth, you’re unfortunately merely a passenger. The returns you might experience on the various asset classes, like rent, interest, dividends and change in share prices – these are all out of your control. Remember how I told you that these returns are driven by the market? It’s important that you realise that it is the market, and not people or organisations that will generate investment returns for you over time. Stock markets and asset returns in general are unpredictable, which means that there is no ‘secret-sauce’ that will allow you to do better than the market. Costs on the other hand, are entirely within your control. You CAN control yourself. Seeking to minimise the costs that are associated with your long-term savings and investments has the exact same benefit as chasing a higher return, except in this case, attempting to manage the costs is not futile, unlike thinking that if you could only find the right guy to invest your money with that you’ll retire comfortably.

Introducing: Fees.

Fees are everywhere in the financial services industry, however the most common you’ll experience in almost all long-term investing are these two.

Fund costs

This is a fee that a Unit Trust charges you every year for investing in it. This can range from something as low as 0.18% (Excl VAT) all the way up to 3.0% (Excl VAT). Unit Trusts are everywhere in South Africa. They permeate Retirement Annuities, Living Annuities, Pension Funds and Provident Funds. If you’re planning on investing in South Africa over the longer-term, you will cross paths with a Unit Trust.

You won’t actually pay the fee directly; rather, the Unit Trust Management Company that administers the Unit Trust will deduct it from your account, but don’t be fooled into thinking that you’re not paying it.

If you don’t know what a Unit Trust is, don’t worry. I will discuss them in detail later on. For now, think of it as a collection of different asset classes that allows you to invest your money easily and quickly.

Advice fees

These are costs not associated with a particular financial product or asset class, but that are charged by a company or person for the advice services that they provide to you. In the context of long-term saving and investing, this might be to a financial advisor or broker, or to another company for some kind of administration services.

The fee can either take the form of a commission, a bill for time spent, or a mixture of the two.

But does it do what it says on the label? You won’t argue that higher returns mean more money every year. More money every year means larger compounding. You must realise though, that all returns are only worth what they say they are, if they’re quoted after fees. If you found an investment that paid 100% p.a. it would all be pointless if the fees were 99% p.a.

Net returns pay the bills.

Net returns equate to cash flow.

Only net returns can compound over time. By managing your costs, you can improve your net returns; this is simple maths.

Protect your net.

Keeping your investment costs low is a critical part of every serious investor’s arsenal. Please listen as I say this now:

“Paying more does not necessarily mean that you will get more.”

If you could get a particular outcome for 1.0% p.a. it would make no sense to pay 2% for that same outcome would it?

If what I’m saying is correct in that nobody can steer the market to generate higher returns, nor can they ‘beat’ the markets and give you better returns than what the market might be able to do over the long term, it must make sense then to only pay as little as possible, to get into the market in the first place?

Every extra rand spent on costs that add no value, is simply reducing your net returns.

This is not only about losing some of your wealth to high costs, as ultimately you’re going to lose a portion of your income too. That is after all why you invest for retirement in the first place. Providing for retirement does not simply mean having a big pile of cash; no, retirement requires your stash to generate an income so you can keep paying the bills when your salary stops rolling in. The less you have due to fees, means the less you’ll have to live off of in retirement.

Here, have some free money

The long-term effects of paying lower fees on your investment returns are identical and as impressive as that of compound returns.

Consider this scenario:

Two thirty year olds both invest R200, 000 on day one. They both earn on average 8% for the next 30 years on their investments. The smart investor pays 0.57% in fees every year, whereas the slightly naïve and apathetic investor pays 1.14% in fees.

The smart investor ends up with a final balance of about R2.2 million, while the apathetic investor will have about R1.85 million.

That’s a difference of about R350, 000 give or take a few rounding’s.

The investor who took the time and made an effort to secure lower cost investments benefited by about 20% over that of the investor who didn’t. This means 20% more income when you retire, which is nothing to scoff at.

When fees DO add value

There are times when some fees do add value. I’m not saying that everyone who charges fees is selling a dream, but you have to ask yourself what the fee is for? If the fee gives you access to a different class of assets that would ordinarily be unavailable to you, that might be a worthwhile expense.

You may pay for advice, which may in itself be worth the fee, for had you not, who knows what poor financial decisions you might have made.

So how do I know if the costs I am being charged are adding any value?

First of all, don’t ask the person who’s charging you the fees; that’s like asking a real estate agent if you should invest in property.

There is no easy answer, as most of the time we have only the benefit of hindsight in evaluating the performance of an asset, and what our net returns have been.

My hope is that as you continue to read these articles and you come to understand how investing works, that identifying costs that add no value will be easy to identify – but it will take time.

For now, all you really have is the ability to compare substitutes.

Given that a lot of what is on offer in the financial services industry and investing landscape, are good substitutes for one another, comparative quotes will be your friends. This is easier to achieve when it comes to getting financial advice from an advisor, as their services are often pretty similar to what the next person will offer you. Having said that, there are good financial advisors and there are bad ones. The bad ones may still try and charge you the same fee as a good one – so be on your guard.

When it comes to investing costs, there is a real challenge here. The reality is that at this stage in your financial journey, you’ll be bamboozled by asset managers and financial professionals who would have you believe that their annual fund costs are adding value; you just don’t have the understanding yet to take them on.

All is not lost. A good financial advisor will be able to guide you to investments that present themselves as being low-cost options, as well as help show you various fee options on all that you might invest in. I will touch on some of these low-cost investments over time, so keep coming back.

If you remember nothing else, remember these few bullet points

  • Fees are not in themselves bad, but fees that add no value to your investment performance or greater personal finance wellbeing are an unnecessary rot.
  • Unnecessary and higher costs will in the long run erode your wealth.
  • Seeking out lower fees is guaranteed to provide you with a higher net return over the long term.
  • Ask any financial advisor or broker what their various fees are for and what commission they will earn; you are entitled to ask and know.
  • Get comparative quotes and educate yourself.

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