A famous quote from Albert Einstein often parroted by the finance industry goes: “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
Although there is actually no proof that this was a quote by Einstein himself, the essence of the quote rings true. In an investing sense, it relates to interest earned on already accrued interest, and its effectiveness in building wealth cannot be understated.
Whilst “Einstein” alludes to the compounding of debt interest in the final part of the quote, it does not tell the entire story of when compounding can work against you.
Your investment returns compound, yes. But what also compounds are lost returns. That is, returns you could have received, or should have received but didn’t for some reason.
So, if all else is kept equal, how do you guarantee that you lose those returns when investing?
Fees
Investment management costs. Platform fees. Adviser fees.
When investing, these are the common costs that you may come across. What they have in common is that they often come in percentage form. That is, they are expressed as a percentage of your asset, rather than a flat fee. For example, a 1% fee on a $100,000 portfolio would equal $1,000 a year. If that portfolio the next year is worth $200,000, the fee becomes $2,000.
Keep in mind that some fees (like adviser fees) may seem to be on a flat basis, but still scale with your investment balance, effectively making them percentage based.
This is important because as your investments compound upward, so does the fee. So not only are you getting hit with the fee each year, but your investments are also missing out on the potential compounding effect if that fee did not exist in the first place and instead remained as profit.
Let’s see how compounding works against you when it comes to fees:
Consider a scenario in which an investor starts with an initial $50,000 and makes another $1,000 per month in additions to the portfolio. This investment is a part of their long-term wealth building plan, so it will be measured over a 30-year time period.
We will compare three different annual fee levels:
0.50%: This is to represent the low-cost investing strategy.
1.50%: This represents low-cost investments with the addition of a 1% adviser fee.
2.00%: This represents a 1% adviser fee in additional to a higher investment fee of 1%.
For comparison purposes the annual return of the portfolio is assumed to be 8% p.a. and is compounded monthly.
Projection of Returns:
What initially looks to be a small difference in fees has caused an almost 30% reduction in overall growth. In many cases, for no reason at all.
“From Little Things Big Things Grow”
In this scenario, compounding has worked both in your favour and against you at the same time. The exponential growth you see in the lines is due to the compounded growth of your investments.
Conversely, the greater difference you observe between each portfolio is also due to the compounding. But this time it’s the fees that compound.
This all seems very obvious, but it would be incredibly easy to overlook the impact of the difference in the fees starting in year one. The below table shows the net return of each portfolio in year one:
The table above displays the difference between the portfolios in year one. It’s a difference that could easily be overlooked. After all, your portfolio still made $3,419 in return in one year!
From little things, big things grow
Justifications
Now, the typical defence to such fees charged by advisers & actively managed funds is the claim that by investing in this manner, you would gain an extra return over investing in simple, passive options. Based on research conducted by SPIVA, investing actively is more than likely to actually hurt your returns, rather than improve them with 85% of funds underperforming the ASX200 benchmark over 15 years.
That’s not to say advisers do not provide value for their fees, in most cases they do, greatly more than the fee charged. However, the value is not necessarily in their ability to select investments that will outperform. As such, the fee structure being based purely on a client’s investment portfolio value makes little sense. Luckily this form of charging fees is falling out of favour. Unfortunately though, in some cases percentage-based fees are being replaced with so-called flat fees that are simply ratcheted up each year manually, conveniently going up just as your portfolio does.
Summary
The lesson here is to be obsessive about the fees that you pay. Make sure that every single fee coming out of your investment account has purpose and is of value because they are one of the only things in investing that you can control entirely.
