Investment fees: how fees and small rate differences cost you

What can you control about your rate of return?

You cannot control what the market returns. You can control almost everything between the market’s return and yours: fees, taxes, idle cash, your own reactions to drops, and the interest you pay on debt. Managing your investment returns mostly means managing those.

The right column is less exciting than picking winners, but it is reliable. A fee you avoid is a return you keep in every kind of market. This guide shows the math, starting with the most common leak: fees.

How much does a 1% fee cost?

Far more than 1%. Put $500 a month into investments for 30 years at 7% a year, and a 1% yearly fee costs about $108,000: a quarter of all your growth. The fee is quoted per year but charged on your whole balance, including everything the earlier fees did not let you keep.

A yearly fee comes straight off the return, so 7% with a 1% fee grows like 6%. That lets you compare the two with one formula:

Where does the $107,728 go? In a month-by-month simulation that charges 1% a year on the balance, you hand over about $54,000 in fees directly. The rest is the growth those fee dollars would have earned over the years if they had stayed in your account.

Investment fee calculator

Enter your own monthly amount, return, fee and years. The table underneath shows the same plan at fee levels from 0.03% to 2%, so you can see what each step costs.

For the example plan, $500 a month for 30 years at 7% before fees ($180,000 deposited):

The longer the money stays invested, the bigger the share a fee takes. The same 1% fee on $500 a month:

What is an expense ratio?

An expense ratio is the yearly cost of owning a mutual fund or exchange-traded fund, shown as a percentage of your money in it. A 0.5% expense ratio means about $5 a year for every $1,000 you hold.

According to state securities regulators (NASAA), it reflects a fund’s recurring charges, such as management, administrative and distribution fees, and it is paid out of the fund’s assets. You never get a bill. The fund’s value is simply a little lower every day, which is why it is easy to ignore. It does not include one-off costs such as sales loads or brokerage commissions, so check for those separately.

When two funds hold the same kind of investments, the one with the lower expense ratio starts every year ahead by the difference. You can find the ratio in a fund’s prospectus.

Other costs to look for

• Sales loads: a one-off charge when you buy or sell some funds. It is not in the expense ratio, so add it on.
• Trading commissions: a charge each time you buy or sell. Frequent trading multiplies it.
• Advisory or wrap fees: a yearly percentage for managing the account, covered next.
• Account fees: flat yearly or maintenance charges. On a small balance a flat $50 a year can be a larger percentage than the fund itself: $50 on $5,000 is 1%.

Advisory fees and fees that stack

An advisory fee is what a financial advisor or managed-account service charges, often as a percentage of the money it manages each year (an “assets under management” fee). It is charged on top of the expense ratios of the funds inside your account.

Advice can be worth paying for, especially for complicated situations. The point is to know the total you pay, in dollars, and to compare it with what you get.

Why does a fee compound like a lost rate?

Because it is charged on your balance, a yearly fee lowers your growth rate every year, and that lower rate compounds. For a single lump sum, the share you keep after a fee is the ratio of the two growth factors:

Read that as a rule of thumb: over a working life, every 1% of yearly fees takes roughly a quarter to a third of what you would otherwise end with.

How do small rate differences add up?

Exactly like fees, in either direction. Half a point of extra yearly return, from lower costs or less idle cash, adds up to tens of thousands of dollars over decades. Here is $500 a month for 30 years:

For a lump sum the effect is even larger, because all of the money is invested for the whole time. $10,000 left for 40 years becomes $102,857 at 6%, $149,745 at 7% and $217,245 at 8%: two points of yearly return, more than double the money.

This cuts both ways. A higher return you get by taking more risk is not guaranteed and can turn into a loss; a higher return you get by paying less is locked in. That is why cost is the first thing to manage.

How can you increase your rate of return?

Start with the levers that do not depend on the market. In rough order of how sure the gain is:

1. Pay off high-interest debt first

Paying off a debt earns you its interest rate, guaranteed. A $5,000 card balance at 22% a year, compounded monthly, costs about $1,218 in interest over a year (an effective 24.36%). Investing the same $5,000 at a 7% planning rate would earn about $350, and not reliably. No ordinary investment beats removing a 22% cost, which is why the leak check looks for card interest alongside fees and subscriptions.

2. Cut your fees

Add up every percentage you pay: fund expense ratios, any advisory fee and any account fee. Use the calculator above to turn the total into dollars over your time horizon. Lower is better when what you own stays the same.

3. Use accounts that reduce tax

Tax on gains comes off your return just like a fee. Retirement accounts change when, or whether, you pay it: the IRS says withdrawals of deductible contributions and earnings from a traditional IRA are taxable, while a qualified distribution from a Roth IRA is not taxed. Which type fits depends on your income now and later, so treat this as a reason to learn the rules, not as advice to pick one.

4. Keep cash drag small

Money in an investment account that sits in cash earns the cash rate. If 10% of the $500-a-month plan sits at 4% while the rest earns 7%, the whole account earns 6.7% and ends about $34,907 lower after 30 years. If 20% sits at 0%, the account earns 5.6% and ends about $144,490 lower. Cash you need for emergencies belongs in savings; cash meant for the long term costs you.

5. Do not sell after a drop

The most expensive return mistake is often behaviour, not fees. The S&P 500 shows what selling after a crash can cost:

Finally, look at how you measure your return. Averaging yearly returns overstates growth, so check the compounded figure when you compare your results with a fee or a benchmark.

A once-a-year return check-up

1. List every debt and its rate. Anything above your planning return goes first.
2. Add up every yearly fee as a percentage, then multiply by your balance to see it in dollars.
3. Check how much of your long-term money is sitting in cash, and why.
4. Check that each account is the kind that suits its purpose, for tax.
5. Write down what you will do in the next 30% drop, before it happens. “Nothing” is a plan.

Most of these are worth a fraction of a point a year. Over decades, as the tables above show, fractions of a point are tens of thousands of dollars.