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

By Markets Fool.com

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.

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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 look at the math.

The long-term effect of fees
In our minds, the difference between a 0.5% expense ratio or asset management fee and a 1.5% fee may seem 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.

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

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Annual Account Fee

Final Account Balance

No fees

$750,000

0.5%

$678,000

1%

$613,000

1.5%

$556,000

Even a low fee of 0.5% severely reduces your final balance, but consider this: The difference between 0.5% in asset-management fees and 1.5% would amount 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 "a person saving for retirement who chooses low-cost investments could have a standard of living throughout retirement more than 20% higher than that of a comparable investor in high-cost investments."

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, right? This question is especially important to investors who are thinking about buying actively managed (and thus more expensive) mutual funds.

While that sentiment makes sense in theory, it's not usually borne out by reality. 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 maintaining their outperformance. The researchers found that even good active managers often have periods of underperformance, which makes it all the more difficult to find an actively managed fund that's worth the extra cost.

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 maintain with any degree of consistency.

So, when looking at investments, aim for the lowest-cost product in a category. Index funds boast extremely low fees, but you'll still find a fair amount of variation among 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 option. The same holds for ETFs and more specialized indexes, like emerging-markets funds. These are more expensive -- usually for a reason -- but that doesn't mean they perform well enough to justify their higher expense ratios. 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.

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. These investors all too often succumb to the urge to micromanage their portfolios, selling when they panic, buying when they're confident, and generally trading too frequently.

Just like high management fees, trading fees can be big performance-killers. 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, but you also pay the performance cost of moving in and out of investments; unfortunately, most investors make trades 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 may 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 that 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.

At the end of the day, it's important to differentiate between fees that are helping you and those that could hurt you. 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.

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

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