by WWM | Apr 4, 2018 | Mutual Funds
Previously, we reviewed mutual fund transaction and operating costs. Both have substantial impact on investor wealth accumulation. Another more obvious component of asset growth is mutual fund performance.
As we have covered investment return considerations a while back, this will be brief. Though a reread of the linked posts may be worthwhile.
Total Returns not Change in Net Asset Value
Always use total return when calculating or assessing fund performance.
Total return reflects the period change in the net asset value of the fund plus any income or capital distributions made to shareholders during the period.
It is important not to forget distributions or your results may seem poor.
Annualized not Cumulative Returns
When reviewing returns for periods greater than one year, the performance figures should be on an annualized, not cumulative, basis.
Annualized returns allow for better comparisons between periods.
Net not Gross Returns
Know what is included in the performance data you analyze.
When assessing fund performance, make sure that you review net returns and not gross.
Net returns are those that factor in fund total expenses when determining performance. As every dollar of expense negatively impacts your own return, you want to ensure that all the costs are factored in to the return calculation.
There is a trend to ensure that net returns are reported, but there are still some differences between regulatory jurisdictions in reporting requirements.
My Fund’s 5 Year Annualized Return was 11%
A fund’s performance is important when assessing potential investments and monitoring existing ones.
But knowing a fund’s return in isolation does not provide much information content.
If my fund returned 11% annually over 5 years, is that good?
Maybe. Maybe not.
To determine the answer we always need to put returns into proper context.
We shall consider relative performance in our next post.
by WWM | Mar 28, 2018 | Mutual Funds
Besides potential sales charges and brokers’ commissions, you incur ongoing fees for the costs associated with operating a mutual fund. These costs can differ significantly between funds and should be reviewed carefully before investing.
Assessing a mutual fund’s cost structure is key to investing success.
Minimizing Fund Expenses is Vital to Investment Success
Capital spent on items other than the actual investment is money that does not earn a return and compound on your behalf. As a fund’s expenses fall into this non-income generating category, they are extremely important to consider when investing in mutual funds.
For example, two global equity mutual funds each had a gross return of 10% last year. Fatcat Global Equity Fund had operating expenses of 5% Assets Under Management (AUM). Lean Global Equity Fund had operating expenses of 2%.
On a net basis, instead of identical returns, Lean had superior performance. If the same returns and expenses continue in the future, over time there will be a significant difference in shareholder wealth.
Perhaps you invested $10,000 in each fund. In rough calculations (ignoring taxes, distributions, assuming annual reinvestments, same annual returns and expenses, etc.), at the end of 5 years your Fatcat investment would be worth roughly $12,750 and Lean worth $14,700. At the end of 10 years, Fatcat would be worth $16,300 and Lean $21,600. After 20 years, Fatcat would be worth $26,500 and Lean $46,600.
Over time, that extra annual 3% in Fatcat expenses will have a significant impact on your compound returns.
Management Expense Ratio
The Management Expense Ratio (MER) reflects the annual cost of operating a mutual fund. Note that some areas of the world call this the Total Expense Ratio to reflect the inclusion of all costs. Then they consider the management fees separately. Just ensure you understand what is included in any fund ratio calculation.
The MER is made up of three fee or expense categories: management; administrative; marketing.
It does not include costs associated with buying and selling fund investments (e.g., commissions, loads, brokers’ fees).
Management Fees
A large portion of the MER is the fees paid to the fund managers or investment advisors.
These are the people that research possible fund investments, determine assets to include in the portfolio, monitor the ongoing performance, and make decisions to sell any assets.
This fee may also include investor relations and fund administration costs, although normally these latter expenses are include in the administrative cost category.
Management fees can be structured in a variety of ways. In the majority of funds though, management fees are based on a percentage of AUM. For example, a fund may have a stated management fee of 0.60% AUM.
In general, the greater the amount of work required from the managers, the larger the fee. So there can be a wide disparity in management fees between funds.
Actively managed funds require more work than passive funds.
Funds that focus on niche markets or areas with relatively poor public information on companies also require greater effort in analyzing and selecting investments.
Funds requiring complex trading strategies tend to need more work than simpler strategies.
When comparing MERs or the management fee itself, always make sure you compare apples to apples.
For example, it might make sense that a management fee between two Africa international equity funds is 2.10% AUM versus 2.00% AUM. One would expect that funds of similar size, investing in the same asset class and region, to have relatively equal MERs (if not, you need to find out why before investing).
But it may make less sense to compare these funds against a U.S. large cap equity fund. The U.S. fund likely has better available research and corporate information on possible investments than do the companies based in Africa. It is reasonable to expect greater work being required to assess African companies. Greater work equates to higher fees.
Or perhaps the U.S. large cap fund has AUM of $10 billion. In comparing that with another fund holding only $100 million in assets, you may expect the larger fund to have a lower MER. For the simple reason that the bigger fund has more assets against which to spread its costs. Would you expect a fund with $10 billion in assets to require 100 times the management costs versus a $100 million fund?
Popular in hedge funds, you may also see performance based management fees on top of the standard charge. The performance fee may be based on on profits earned (e.g., 20% of all positive returns), on profits above a designated “hurdle rate” (a benchmark return such as the U.S. Treasury Bill rate, the S&P 500, etc.), or on profits above the “high water mark” (the highest previous return for the fund).
Administrative Costs
Administrative costs cover the back-office costs of operating a fund.
These may include: legal fees; accounting and auditing expenses; record-keeping and regulatory filings; shareholder and other statement preparation and distribution; custody services; staff salaries; rent and utilities on office space.
One would expect that greater administrative costs would be attached to larger funds. And that is probably a fair assumption in hard dollar terms.
However, as administrative costs are also reported as a percentage of AUM, larger funds may appear to have lower costs. This is an advantage of aggregating one’s capital in a mutual fund. You can spread out the administrative costs amongst many investors, creating an economy of scale that benefits you. Same as with fund management fees.
Perhaps ABC fund has annual administrative costs of $2 million. DEF fund has administrative costs of $3 million; 50% greater than ABC. But DEF has assets of $3 billion, whereas ABC only has assets of $1 billion. This equates to 0.2% of AUM for ABC, but only 0.1% for DEF. While ABC has lower administrative costs in absolute dollars, DEF has a better ratio.
Note that while this ratio might be interesting, it really tells us nothing as to whether either ABC or DEF is well-managed.
The best one can do is to compare the costs to funds of similar size and in the same investment categories.
Marketing Costs
Often mutual funds break out their marketing and distribution expenses.
In the U.S., these fees are known as 12b-1 fees. The designation refers to a relevant section of the Investment Company Act of 1940.
In the U.S., a maximum of 1.0% of the fund’s net assets may be used for marketing the fund.
It may seem strange to pay an annual fee to market a product that you already own. The belief is that by marketing a fund, it will attract new investors. New investors will add to the asset base, creating an economy of scale for the administrative costs. This will result in net savings for shareholders.
I have not seen any evidence to support this contention. And in this age of mutual fund investing, investors look primarily at performance and costs when screening funds. What they may see on a television advertisement or hear about from a sales representative is way down the list of review points. Or it should be.
I consider these costs a waste of money for investors and suggest you do the same.
Total Expense Ratio
Neither the sales charges nor fund transactional costs are included in the MER.
The sales charge (i.e., commission or load) is not a fund expense. Rather it is a direct cost to the investor. It makes sense that it is not included in the fund’s cost structure. Same if you have to pay a brokerage fee to buy or sell the fund.
Transaction costs incurred by the fund when buying or selling fund portfolio investments (e.g. brokers’ commissions, spread differences, etc.) are expenses of the fund.
Total expenses are calculated by taking the management expenses (management fee, administrative, marketing) and adding in the transaction costs.
To obtain the total expense ratio (TER), simply divide the fund’s total expenses by the fund’s total assets (AUM). As stated above, many jurisdictions now blend MER and TER, so you may only see the MER stated. If so, it should also include these internal trading costs.
To further complicate matters, sometimes TER relates only to Trading Expense Ratio. So it is separate from, rather than cumulative with the MER. Anything to confuse investors. And yes, that is a goal of fund companies.
Internal Transaction Costs
In assessing funds, perhaps one fund has a relatively high TER versus its MER. That means the transaction costs are high. This can be due to poor order executions, high spreads between bid and ask prices, or high portfolio turnover.
High transaction costs may be a red flag when deciding to invest. Unless high frequency trading is the strategy.
If the fund is not doing a good job of executing trades, it may not be getting the best prices on its investments. It may also be paying too much in commissions. Both of these negatively impact returns.
High turnover means more frequent trades (and costs), which impairs profitability (unless that is the strategy).
High turnover may indicate that fund management lacks confidence or patience in their investment selections with all the selling of current holdings and replacement with new assets. This could be a warning about their future performance.
In some instances, it may indicate churning. That is, excessive trading within an account to drive up brokers’ commissions. Less a problem with mutual funds than in other circumstances (e.g., managed accounts), but it can still occur.
Finally, every time an investment is sold, there may be a tax implication for fund shareholders. Generating capital gains too early can accelerate the shareholder’s personal tax obligations and hurt compound returns.
Conclusion
First, when assessing fund costs, always compare like funds. Size, style, geographic region, asset classes, etc., they all impact the cost structure. Compare within the category in which you wish to invest if you want meaningful analysis.
Second, all else equal, choose funds with the lowest expenses. Unless you truly believe that a higher cost fund will generate superior net returns than a lower cost option, stick with the lowest cost possible.
Of course, that is not to say that you should invest in under-performing funds simply because they are cheap. But do place a heavy emphasis on costs when you do your total analysis.
Remember, future returns may or may not be the same as past performance. But there is a high probability that the cost structure of a fund will be consistent in years to come.
As we saw above, what may seem like small differences in costs will create substantial variances in investor wealth over time due to compound returns.
Make your money work for you.
Maximize the amount invested and earning actual returns.
Minimize the money you pay to others and receive no return on.
by WWM | Mar 21, 2018 | Mutual Funds
We previously reviewed the perceived advantages of investing via mutual funds. Funds are a great way for investors to build well-diversified portfolios and meet long-term investment objectives.
However, there are potential downsides. Not necessarily negatives, but areas investors need to be aware of and take measures to protect themselves against.
This is why we diverted to the concept of compound returns over the last few posts. How time horizon, cost structure, and rate of return can greatly impact long term wealth accumulation. Even 1% here or there can alter asset growth.
We will consider how mutual funds (or any investment) may negatively impact your annual net returns and thereby significantly impair wealth accumulation. Today, transaction costs incurred when buying and selling open-end mutual funds.
The Importance of Transaction Costs
As we saw in compound returns, every dollar you pay to someone else is a dollar of extra returns that must be earned just to break-even. And every dollar lost, is a dollar that cannot compound over time. A significant problem for investors attempting to achieve long-term portfolio growth.
Transaction costs can be a major expense when investing. Less so now that most investors use online brokerage accounts. $10 per trade is easier to handle than in the days of full service brokers.
As well, the introduction and proliferation of exchange traded funds has worked to reduce loads (and, as we will review later, expense ratios) in mutual funds.
Mutual Fund Transaction Costs
Funds may be subject to a sales charge when investors buy or sell shares or units of the fund. This transaction fee compensates brokers or internal fund salesmen for selling investors the fund.
The fee is known as the load or sales commission.
You may encounter front-end, back-end, or declining loads. Some funds may offer more than one option.
Note that different load options may result in other different terms or conditions. For example, a no-load fund may charge higher annual fees than the exact same fund with an upfront sales commission. Clearly understand the total fee structure, including ongoing costs, before choosing a load option.
Although similar to the broker’s commission when you trade a marketable security, be aware that a load is not a commission in that sense. If investing directly via the mutual fund company, there should be no broker’s transaction cost. Two different concepts.
Front-end Load Funds
A front-end load is paid to the mutual fund company when you purchase units or shares of the fund. In future, when you sell the investment, there is no load paid.
For example, on January 1, 2018 you invest $1000 in an global equity fund that has a a 5% front-end load and a closing net asset value (NAV) of $50 per share. You will pay $50 as a sales fee (5% of the $1000) and receive 19 shares of the fund with your remaining $950.
And yes, your fund has a lot of work just to recover the compound returns you will lose over time on that initial 5% load.
Back-end Load Funds
A back-end load is the opposite of a front-end load. Instead of paying a sales fee when you purchase shares of the fund, you pay a fee when you sell.
As you pay the transaction fee only at the end, back-end loads are also known as deferred loads or deferred sales charges.
Using our previous example, let us say that the 5% load is a back-end instead of front-end.
Had you invested $1000 in the global equity fund at $50 per share, you would receive 20 shares as the entire amount would be available for purchase.
Perhaps in 6 months the fund rises to a $60 per share NAV. You decide to sell your 20 shares and will have gross proceeds of $1200. As you now have a deferred load, you must pay the 5% sales fee. But not on the initial capital invested as in the front-end. Rather, you will pay on your gross proceeds. In this case, you will be charged $60.
The trade-off between the front and back-end loads is two-fold.
As you hope to experience appreciation in the value of the fund, you should expect to pay more for a back-end load with the same percentage fee than with a front-end load.
Because of the time value of money, the longer you hold the shares, the better the back-end load will look. If you intend to keep the investment for a long time and have a choice between equal fees, back-end funds should be the better option.
Declining Load Funds
Many back-end loads offer declining sales charges over time.
This is an incentive for investors to stay in the fund for longer time frames.
For example, perhaps the back-end load is structured as follows: 5% sales charge if sold within 3 years; 3% sales charge if sold after 3 years but before 7 years; 0% if sold after 7 years.
If you do not sell for at least 7 years, you will not be charged any fees.
In our example above, you consider selling your fund shares on December 31 in the years 2018, 2022, and 2027. The per share NAV on those three dates is respectively $60, $80, $100.
With a declining back-end load, you would pay a sales charge of $60 (2018), $48 (2022), and $0 (2027). The longer you hold, the better the deal. In this example, the dollar value sales charge decreased even though the total assets grew over time.
Often, declining loads appear very reasonable as many investors plan to hold onto funds for extended periods. However, be aware that the best of intentions often go awry. Personal circumstances may change and you may need to divest before the back-end load falls to nil.
As mentioned above, check to see how a back or deferred load may result in other charges or expenses. If you save money on the commission, you may just be paying for it under another guise.
No-load Funds
No-load funds do not charge a sales fee.
All else equal, no-load funds are more desirable to investors than any type of load fund.
Every dollar of investor capital goes to acquire shares of the fund. And every dollar of gross proceeds upon sale is due to the investor. None of the investor’s funds go to pay the salesman.
Of course, load fund salesmen will make compelling arguments as to why paying a sales charge to acquire a particular load fund is worth the fee.
While their load funds may be excellent, always keep in mind that the salesman is paid for selling the fund. I would add that “excellent” is a relative term. You need to assess whether the expected performance of the fund over time justifies paying someone for the privilege of owning it.
Many salesmen may be principled and want to find the you best fund for your needs. But some salesmen may push customers towards funds that provide them with the best sales charge. When dealing with people selling load funds, always be cautious as to their intentions.
Of course, the same caveat as with deferred loads is true for no-loads. You need to examine the other fund costs to see if you are paying a hidden commission.
Commissions on Mutual Funds
As I wrote above, a sales charge is not a broker’s commission. It is compensation from the mutual fund to the salesperson.
Open-end mutual funds are bought and sold directly from the mutual fund company. They do not trade on exchanges and you do not require a broker to transact trades on your behalf.
That said, to improve investor accessibility to mutual funds, many fund families allow investors to buy and sell funds through the investor’s brokerage account.
So if you purchase open-end funds (load or no-load) through your broker, you may be required to also pay a commission to the broker.
Not all funds are available through all brokerage firms. Some can only be purchased or sold directly through the fund company. Other funds may only be bought or sold through specific brokerage houses.
The number of funds sold can vary substantially between brokers. If you plan to invest in mutual funds, select a broker that offers access to a wide variety of funds.
As an aside, remember that we are discussing open-end mutual funds here. There are also closed-end funds. Closed-end funds do trade on exchanges and you do need to trade them through a broker. You do not buy or sell closed-end funds via the fund itself.
Closed-end funds do not charge any load. But they will always have a broker’s commission. And, as we shall see later, the same is true for exchange-traded funds.
No-Transaction Fee Funds
If you can buy a no-load mutual fund directly from the mutual fund company and not have to pay any broker’s commission, why would you ever buy a no-load fund through your broker?
Good question.
Outside of wanting to keep your investment portfolio all in one place (without having to set up accounts for your stocks and bonds at TD and your mutual funds in additional accounts at Fidelity and Vanguard), I do not have an answer for you.
I guess many other investors could not come up with reasons either.
Which leads to no-transaction fee funds.
Most brokers have arrangements with certain mutual fund companies to sell funds without charging a brokerage commission. This levels the playing field between fund companies and brokers and allows investors to access a variety of funds without incurring brokers’ fees.
There may be differences between brokers as to which fund families they will waive their commissions on. So check ahead before making investment decisions (or even choosing a broker to deal with).
The brokers give up their commissions to incent customers to buy funds through them. However, no-transaction fee program fund participants typically pay a fee to the broker each time a no-transaction fund is traded. This remuneration from the mutual fund company to the broker is a cost to the fund. And that cost is passed on to fund shareholders, thereby negatively impacting fund performance.
So even though you are not paying commission on the transaction, you will pay indirectly.
Load, No-Load or No-Transaction Fee?
I take a “best of breed” approach to investment recommendations. That is, I try to find the fund that best meets the needs and objectives of a client. My business model excludes my receiving commissions, etc. I have no vested interest in any funds. You pay my fee, you get what is best for you.
That said, with a few exceptions, I do not generally recommend load funds to investors. There are so many no-load options available that you have ample selection for all your portfolio needs.
Exceptions might relate to niche funds that specialize in small market segments where there are no suitable no-load alternatives. For investors starting out or simply wanting to create a well-rounded investment portfolio, I likely would not recommend niche funds anyway.
Exceptions might also relate to load funds with superior net long-term performance. Though this tends not to be the case. Research indicates there is no correlation between loads and fund performance. However, in assessing individual funds, a specific load fund might have superior returns over a similar no-load fund.
You will pay for a fund’s costs in one form or another. Just because you are not paying a sales charge does not mean you are not paying any fees. They may just be buried amongst other expenses. Always focus on a fund’s overall costs and its management expense ratio when deciding on the right fund.
One final comment. Sales commissions may be negotiable. It often depends on the fund company and the level of assets you intend to purchase or bring in. But if you do not ask, you will never get. And every dollar saved, is worth a lot more over time in your portfolio.
Okay, enough on mutual fund transaction costs.
We will take a further look at fund costs later.
Specifically, annual fund operating costs and the management expense ratio.
by WWM | Mar 14, 2018 | Compound Returns
Want to become a millionaire?
Unless you are counting on that big inheritance or playing the lottery every week, your best shot is through investing.
Keys to Compound Return Benefits
The key is to start when you are young. The amount that you invest is somewhat less important than the time frame. If you are not young, start now. You can still benefit from compounding, though to a lesser extent.
Prudently invest on a consistent basis and let the power of compounding do its thing. We will examine what might constitute “prudent” investing in due course.
Utilize tax-free or tax-deferred investment accounts to enhance compounding impact. Look to low-cost investment products to reduce fees and expenses. You want your money to compound on your behalf. Not to enrich the government, investment company, or your friendly financial advisor.
For more detail on these points, please review, “Compound Returns” and “Compound Return Investment Lessons”.
Compound Returns in Real Life
Please consider the story of Nicole and Matt. Not quite an Aesop Fable, but good moral lessons contained within.
The Ant
Nicole is turning 25 years old, has just started a new job, and wants to begin saving for her retirement. She decides to save $300 per month in a tax-deferred retirement account.
Based on historic returns, she expects to earn a net 8% per year in a family of no-load diversified mutual funds that reinvest any income earned back into the funds. We will assume that income compounds semi-annually.
Following this strategy, by age 40, Nicole will have invested $54,000 in total. However her asset value will be worth $104,504 due to the 8% net annual return and compound growth.
If Nicole is wise, she will increase her monthly contributions over time as her salary increases. She will also continue investing until the day she retires.
But at age 40, Nicole decides to set up a separate investment account with her husband and no longer contributes to her first plan. Nicole does not liquidate her initial retirement plan so that $104,504 will continue to grow at 8%.
At age 70, Nicole terminates her individual plan. She is surprised to discover her asset balance has grown to $1.09 million.
For a relatively brief commitment of 15 years and $54,000, she became a millionaire. Not too bad.
And the Grasshopper
Matt is Nicole’s twin brother. Matt has a well-paying job but he always seems to spend as much as he earns. At month end there is nothing left to save, although he does have a nice tan from his recent vacation to Hawaii.
As he turns 40, he notices that Nicole has done quite well from her monthly saving plan. Wanting to copy her success, Matt visits a financial planner.
Matt knows that Nicole has stopped saving. With 30 years to invest, twice the time frame as Nicole had, Matt figures that it will be simple to catch up with her. Maybe he can even do so with less than $300 per month. That would be great.
Matt instructs the financial planner to create an identical investment strategy as Nicole. That is, the same diversified portfolio of low-cost mutual funds netting an 8% annual return with income semi-annually compounding.
Unfortunately, Matt does not understand the concept of compound returns. So he receives quite the shock when he gets the financial planner’s program.
To catch Nicole at 70, Matt must invest $750 monthly for 30 years in an account earning 8%, compounded semi-annually.
Nicole invested $54,000 over a 15 year period.
To match her accumulated $1.09 million in wealth, Matt must contribute $270,000 of his own money over 30 years.
Matt must find more than double the cash that Nicole invested each month and he must do so for twice the time frame. In total, Matt must pull five times the cash out of his own pocket to achieve the same result as his sister.
A lot more sacrifice for Matt to amass the same wealth as Nicole. Smart lady.
Moral of the Story
That is the power of compounding.
Start investing as young as you can. The longer the time frame the better.
The sooner you begin, the less you actually need to invest in total contributions.
Even relatively small investments can grow to large amounts over a long time period.
Return is crucial. Gross returns on the investment itself. But equally so the net returns after fees, costs, and taxes.
Had Matt been able to net 9% annually, rather than 8%, he could achieve almost the same total investing only $600 monthly. If his return was only 7%, he would need to make monthly contributions of $900.
At the 8% return, Matt’s monthly contribution of $750 for 30 years grew to $1.096 million. Now let us say that the mutual fund company he chooses charges a 1.0% annual management fee on the funds. Not a lot as far as most charge. And really, what is 1.0% among friends?
However, that reduces his net return to 7% and his assets only grow to $902,000. A decrease of $194,000 in wealth.
A percentage of return paid to a fund company, bank, or advisor annually, has enormous long term ramifications your wealth. Finance your own retirement, not someone else’s.
by WWM | Mar 7, 2018 | Compound Returns
We compared the investment return concept of simple versus compound in Compound Returns. We saw how compounding may actually result greater asset growth than that from an investment alone.
Today we examine some very important investing lessons resulting from the power of compounding. If you understand and adhere to these lessons, you will improve your investing results and wealth accumulation.
For all the lessons below, we shall use the same basic data from the following example:
You invest $1000 in a bond fund earning a 10% rate of return, compounded annually. Earned interest is automatically reinvested in additional fund units. Changing interest rates, capital gains or losses, taxes, and transaction costs are ignored. After 10 years your investment will be worth $2594 ($1000 initial investment, $1000 interest on your capital; $594 interest on compounded reinvested income).
Assuming all other variables remain unchanged, here are the key investment lessons:
The longer the investment period, the greater the impact of compounding.
Time is a crucial component for compounding.
In our example, after 10 years your initial investment grew to $2594. Not bad. But if you leave that money alone for 50 years, your one time investment of $1000 grows to $117,391. Impressive.
Over that 50 years, you only earned $5000 (50 years X $100 per year interest) in simple return. The rest of the increase is due to compounding. That is, interest earned on interest.
The farther out the year, the greater its impact of compounding.
After 10 years at 10%, you end up with $2594.
If you need the cash after year 9, you only get $2358. Not that bad, but you lose more than just the $100 simple return in year 10. You also lose an extra $136 in interest due to lost compounding. Not great, but not too bad.
However, if you need the money in year 49, you only receive $106,719 versus the $117,391 if you held out until year 50. That lost $10,672 is huge. And almost all of it reflects the compound interest effect over the years.
The longer you can keep money compounding, the greater the incremental impact. Think of that before accessing your tax-free or tax-deferred investment plans.
The higher the rate of return, the greater the impact of compounding.
All else equal, the rate of return has a big influence on performance.
At a 10% compound return, a single $1000 investment grows to $2594 in 10 years and to $117,391 in 50 years.
Had you found an extra percent return, the impact is noticeable. Over 10 years, you end up at $2839, an improvement of 9.5%. Over 50 years, you get $184,565, a change of 57%.
A big concern with investment product fees that reduce net returns. If you own a mutual fund that charges 1.5% annually, that 10% return nets to 8.5%. Your bond fund now will be worth only $2261 in 10 years and $59,086 in 50 years.
Over 10 years that “fee” to the fund company reduces your wealth $333. Over 50 years, $58,305. And that is all based on you investing a mere $1000. Think of the wealth accumulation differential if you invest a $100,000 or more.
That is a lot of money you are giving away to the mutual fund company in exchange, I expect, for “free advice.” Let your wealth compound in your account, not in the fund company’s coffers.
The more periods in a year an investment compounds, the greater the impact of compounding.
The greater the periods, the more times interest will be calculated, the sooner the next round of compounding can begin.
May sound odd, but think of a home mortgage. The more payments made in a year, the quicker the principal falls. Even if the aggregate value of payments in a year is equal.
In our first example, interest was compounded on an annual basis. That gave us the end values of $2594 over 10 years and $117,391 over 50 years.
Compounding monthly, our investment grows to $2707 in 10 years and $145,369 in 50 years.
And daily compounding results in asset values of $2718 in 10 years and $148,312 in 50 years.
Exactly the same investment with the same time frame. Yet just by accelerating the compound periods you are able to increase your overall return.
The less your costs, the greater the impact of compounding.
Costs such as taxes, sales commissions, management fees, and transaction costs, all reduce your monetary return. Less return translates into less money being reinvested. That significantly affects the power of compounding over time. Be very aware of this.
We saw the impact of fund fees above. Taxes are another huge area to try and minimize and/or defer.
Without being too detailed, let’s assume you pay a reasonable 30% tax rate on your earned income. So for each $100 in interest you earn, only $70 can be reinvested. In essence, your annual return has fallen to 7% from 10%.
In our example, your $1000 would only grow over the 10 years to $1967 and not $2594. The government took $300 in taxes, but you also lost $327 in compound interest.
Annoyed? If so, stop reading.
Over 50 years, you only finish with $29,457 and not the $117,391 before tax.
Take advantage of available tax-free and tax-deferred investment accounts.
The same holds true for other costs, such as management fees and transaction costs. Money paid to others will not accumulate on your behalf. 1% fees here or there may seem like nothing. But as we saw above, they can be massive over time.
We will look at ways to minimize costs at a later date.
Conclusion
The younger you begin to invest, the longer the time horizon until retirement. This is great for compounding returns.
Being younger also allows you to take on higher levels of risk in an attempt to earn better returns. Again, something very useful for compounding growth.
The later in life you begin to invest, the more at a disadvantage you will be. But the longest journeys begin with a single step. You just may need to allocate more to your portfolio to offset the lesser compound returns.
Additionally, as you can see from the lessons, minimizing your investment costs is crucial to long term growth. We will look at cost minimization strategies as we go along. But the keys are to avail of tax-free or tax-deferred savings plans and to minimize investment expenses paid to your advisors, fund managers, banks, etc.
Always let your wealth compound on your behalf. Not someone else’s.
I hope this clarifies the concept of compound interest and that you begin to take advantage of it.
Next up, realistic examples on how these compounding lessons impact wealth accumulation.