How to Ruin Your Portfolio Performance: The Power of Fees and Time

By Markets Fool.com

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For most people, investing isn't all that easy. Between asset allocations, risk profiles, and the simple matter of funding your investment accounts, there are numerous decisions to make and a lot of conflicting information about how to make them.

One piece of advice, however, is notable for its simplicity and its staying power: pay attention to fees. The more you pay -- for your mutual fund expense ratios, for sales loads, and for your financial advisor -- the worse your performance will be.

Don't believe it? Just take a look at the math.

The long-term effect of fees
In our minds, the difference between a 0.5% fee and 1.5% expense ratio or asset management fee might feel so small as to be almost insignificant -- but the long-run effect of that tiny difference is enormous.

Let's say you're investing $500 per month into a retirement account. You do this every month for 30 years, and your account enjoys an average annual growth rate of 8% per year. Assuming you don't make any withdrawals or interrupt your savings, you'll have accumulated $750,000 in savings after all that time.

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Now, enter fees. Here is how those savings look at different fee levels:

Annual account fee

Final account balance

No fees

$750,000

0.5%

$678,000

1%

$613,000

1.5%

$556,000

It's already a bit of a shock to go from no fees to 0.5%, but consider this: the difference between 0.5% in asset management fees and 1.5% amounts to $122,000 in lost savings over the course of your lifetime. That's about 16% of your "no fees" account balance.

The research literature backs this up. Economist William Sharpe estimates that low-cost index fund investors will have about 20% more money in terms of purchasing than an investor paying higher fees. In other words, people who spend less on fees tend to have more money to retire with.

What about performance?
The first question that you might ask when presented with this kind of information is simple: "What about performance?"

After all, if higher fees are delivering higher returns, then surely they're worthwhile? This is especially of interest for investors thinking about using actively managed (and thus more expensive) mutual funds.

While the sentiment makes sense in theory, it's not such a simple matter in practice. Finding mutual fund investments that can consistently beat the market is far from easy. By one estimate, the Vanguard Total Stock Market index beat active managers 77% of the time. Another study from Vanguard demonstrated that even outperforming active managers have a difficult time keeping up their performance. The researchers found that even good active managers often have periods of underperformance, which makes selecting one that's worth the extra cost all the more difficult.

This is especially complicated when you consider the level of performance required to make up for extra fees over time. In the example above, where we assume a "baseline" performance of 8%, the manager charging a 1.5% percent fee would have to provide an average of 9% returns over the long run in order to make up for the extra cost of the fund. Again, whether that is possible or not in any given case is pretty much impossible to predict -- and even if you get it right in the short run, outperformance is difficult to keep up with any amount of consistency.

So, when looking at investments, try to aim for the lowest-cost product in a category. Index fund are very powerful for this reason, but -- quite remarkably -- you'll still find a fair amount of variation in between them. All S&P 500 index funds hold the same investments, but they don't all charge the same fees, so do your homework and try to find the lowest-cost alternative. The same holds for ETFs and for more specialized indexes, like emerging markets funds. These are more expensive, usually for a reason, but that doesn't mean that they're worth a significant expense ratio. If you want to invest in these asset classes, shop around for the cheapest index fund or ETF -- or even consider individual stocks if they make sense for your portfolio.

When does paying more make sense?
There is a major caveat to the wisdom of paying less. For some investors, staying invested in a single strategy is incredibly hard -- especially where emotions and dreams about retirement are involved. For these investors, it might be well and good to invest in a portfolio of low-cost index funds and possibly individual stocks in theory, but in practice it might be very difficult to then leave the account alone.

These are the kinds of situations that can cause panicked selling or elated buying, both of which involve extra trading and its common counterpart: buying into overheated markets and selling into downturns.

Just like high management fees, trading fees can be a powerful performance killer. Even if you only pay $5 per trade, the cost of trading repeatedly adds up quickly over time. Why? Not only do you pay the price of the trade, you pay the performance cost of moving in and out of investments. Unfortunately, for most investors those moves usually happen at the wrong time.

In these situations, paying a little extra for professional help can be worth it.

A good advisor can help you to stay the course when the going gets tough: and when it comes to investing, the going will almost certainly get tough at some point. While you might still want to be on the lookout for high-cost products, an advisor can help soothe your mind and keep your investment strategy on track.

The kinds of fees you pay and the amount will depend on your arrangement with your advisor: some advisors charge commissions, others work on a fee-only basis, and still others might offer a consultation fee for their time. There is no one arrangement that works best in all situations. For example, a commissions-based payment structure makes sense if you have a smaller account which you don't trade often, while a fee-based option might make sense if you have a significant amount of assets. If you prefer to manage your own investments, a consultation fee would probably make the most sense.

In any situation, you want to ensure that you understand the specifics of what you're paying for and what it amounts to on an annual basis. This will at least give you a starting point to make an apples-to-apples comparison of different fee arrangements and advisors.

While it does come with a cost, the stability of an advisor can help provide peace of mind, which in turn can help you reap the benefits of long-term reinvestment -- without incurring the additional costs of trading or, still worse, trading too much at absolutely the worst time.

Pay less, and know what you're paying for
At the end of the day, it's important to differentiate between fees that are helping you and those that could hurt you.

Active management is a good idea in theory, but because of its higher costs, it often falls short in practice. If you can stand by your strategy and avoid rash investment decisions based on emotion, then investing on your own with low-cost products is a great way to go. Consider index funds, ETFs, or even individual stocks to build a portfolio that won't suffer from high fees. And remember that "passive" doesn't necessarily mean "cheap" -- even today, there are huge price differences for funds that have the exact same underlying investments. By shopping around, you can save yourself a lot of money over time.

If you're concerned about managing your own portfolio -- or your emotions -- consider consulting with an advisor. A good one will be worth the money it takes to help you to make a plan and stick with it. Just be sure to understand how much you're paying and what you're paying for. This way, you can compare services and do the math on what the real cost over time will be. Being fee-conscious can also help ensure that you're paying only for what you need. For example, there's no reason to pay for routine management fees for a "set it and forget it" portfolio, and if you just need some help with portfolio construction there's no reason to pay management fees at all -- a simple consultation fee could very well suffice.

Fees aren't all bad in and of themselves, but they can do a great job of eating away at your performance if you're not careful. When it comes to investing, look to minimize your fees to the greatest extent possible, and only pay more if it will help you build wealth over the long run. This ruthless focus on cost might be prosaic, but it's undeniably powerful.

This article originally appeared on wiseradvisor.com.

The article How to Ruin Your Portfolio Performance: The Power of Fees and Time originally appeared on Fool.com.

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