It is tremendously important, as you negotiate over your investments and other financial matters, that you keep an eagle eye on costs. After all, one of your most important goals is to maximize the return on your money. Excessive costs will diminish your outcomes and, over time, reduce your holdings by far more than you might realize.
Among the most important messages from financial scholarship it that costs matter. I devote a chapter to this in Negotiating Your Investments but am merely keeping myself in good company. It is a major theme of works by professors Burton Malkiel, William Sharpe, Ron Rhoades and others. And, of course, Jack Bogle has made a career of preaching this gospel. The long term cost of “financial intermediation” on investment returns is astonishing.
Keep in mind that the calculation of multi-year returns is not linear. The rates of growth, in light of compounding, can be amazing. At the very least, the mathematics of compound interest is not intuitive for most of us. Imagine, for example, if two people had three children and each of their three kids had three children and so on through the generations. It gets to be a whole world full of people a lot faster than you might expect.
In any given situation, you can always get out a “compound interest calculator” and crunch numbers. Many people fail to do that, though, and relying on intuition is usually a mistake. My job here, though, is to focus attention on the simple fact that these numbers are too big to ignore. Here is a single example.
Let us start with a working woman who has $100,000 in a retirement account. She adds nothing more to the account for 30 years and the underlying investments grow by an average annual rate of return of 8%. At the end of the 35 year period, the retirement account will grow to almost a million and a half dollars ($1,478,534 to be exact). Now consider the loss of 2% of that return each year to financial intermediaries of various sorts. (You know; brokers, dealers, agents, insurance companies, financial middlemen, mutual funds, etc.) Our retirement saver is now actually achieving a 6% return. Our intuition expects the gain to be reduced by about a quarter. In fact, though, the account will only grow to $768,608. In this example, the 2% of annual costs imposed on the investment portfolio over 35 years took over $700,000 out of the saver’s pocket. Even more surprising, though, is that as a result of “middleman costs” reducing the annual return by ¼ each year the final amount is lessened by over 48%.
Nobody can afford to ignore this; it demands your attention. Consider very carefully the next time someone knowledgeable advises that your company’s 40(1)(k) Plan stinks, or to forget that annuity product because it carries 2½ percent in annual costs, or to avoid some investment because it is too expensive. Such counsel is simply too valuable to ignore.
The big lesson: costs matter to investors. The effect of excessive fees, expenses, or anything else that takes a cut out of returns are much more significant than you would imagine. Don’t ignore them, don’t pretend they are but a minor nuisance, and don’t throw your hands up in frustration. Rather, learn about them. Evaluate them. And, to paraphrase Hamlet, “take arms against [these troubles] and, by opposing, end them.”