By Paul Philip CLU, CFP Financial Wealth Builders Securities.
Special to the Financial Independence Hub
In the first two installments of our three-part “Hidden in Plain Sight” investment strategy series, we’ve covered the importance of staying invested to earn market returns, while managing the risks involved. We’ll conclude with what may be the most obvious and powerful piece of advice of all, even if it does not seem to receive the attention it deserves.
Plain-Sight Strategy #3: Controlling Costs
Don’t spend more than you need to.
Why do investors spend more than they need to on their investments?
Revealing the Numbers
While spending less to earn more seems obvious, the costs themselves aren’t nearly as apparent. Disclosure requirements exist in most developed countries but too often the focus seems to remain on adhering to the letter rather than the spirit of the laws.
For example, in spring 2015, the Canadian Securities Administrators (CSA) published a report, “Mutual Fund Fee Research, written by an independent research firm that the CSA commissioned for the task. Far-reaching in scope, the assessment included reviewing the body of existing research on mutual fund fees from the US; other developed markets including Canada, the UK, the EU and Australia; and several smaller markets such as Spain, India and Scandinavia.
Among other things, the analysis looked at what existing research had to say about compensation models found around the world, and investors’ ability to make sense of those many models. One of the report’s strongest findings is telling on that front: “[M]ost investors are unable to understand and assess different forms of compensation.” That is, most investors across a range of global regulatory environments are having a tough time determining the costs and conflicts of interest involved in the investment choices they are making.
The issue does not just affect individual investors. The CSA report observed (emphasis ours): “The sheer variety of possible forms of compensation makes comparison difficult, both for investors and for researchers seeking to understand the impact of different forms of compensation in the market.”
Crunching the Numbers
Adding to the challenge, many investors don’t realize how seemingly modest costs can lead to significantly different outcomes over time. For example, this U.S. Securities and Exchange Commission (SEC) Investor Bulletin illustrates how a $100,000 USD investment earning 4% annually over 20 years would accumulate $220,000 USD. If you calculate the earning power lost by removing instead of reinvesting a modest 0.25% annual expense, which is in the typical range for a low-cost index fund, you sacrifice about $10,000 USD. Bump that to the 1% annual expenses (or higher) that are often found in higher-cost, actively managed funds, and you’re giving up closer to $40,000 USD.
To put these numbers into context, financial author and U.K. hedge fund professional Lars Kroijer had this to say in an interview posted in the Evidence-Based Investor forum: “It’s very, very hard to exaggerate the importance of cost, especially in the long run.” Kroijer compared the experience of a Londoner of modest means, earning in the range of £50K annually and investing 10% of those earnings into equities each year from age 25 to 65. He estimated the following (emphasis ours): “On that person’s 67th birthday the difference in their life savings between having invested in an index tracker [lower costs] and an active manager [higher costs] would amount to the same cost as roughly seven Porsche cars. This is someone who will never drive a Porsche, yet that’s the staggering difference in cost.”
Demanding the Numbers
To differentiate fair compensation from excessive overreach, financial professionals and investors alike should insist on clarity wherever it seems lacking. As Vanguard founder Jack Bogle describes in this CNBC article, “If you had a crowd of investors who said, ‘Look, this is just wrong,’ [fund company] directors would have to listen, whether they want to know or not.”
Instead, there is considerable evidence that, even when investors should be credulous consumers, they seem unwilling to question the costs. Instead, they are often succumbing to behavioral biases that lead them to make choices that run counter to their own best interests. For example, the aforementioned CSA report observed that, despite overwhelming evidence indicating that higher fees have been strongly correlated with lower expected returns, “Many investors affirmatively believe that higher fees in particular lead to better performance.” The report concluded: “With 40% of Canadians failing a general investment knowledge test and many demonstrating unrealistic expectations for investment returns … it is clear that many investors don’t wish to spend a significant amount of time on financial matters.”
The Costs Involved
In short, the first step in managing investment expenses is to know what they are. A detailed analysis of all-in investment costs is beyond the scope of this series, but here we will offer and overview.
Trading costs – When you buy or sell funds, stocks, bonds or other securities, you pay a broker a commission to place your trade. These commissions are typically disclosed in your custodian’s trade confirmation statements.
Fund management costs – If you are investing in funds versus individual stocks and bonds, you’ll pay anywhere from a lot to a little to the fund company that manages them. These costs typically appear in expense ratio disclosures in a fund’s prospectus or listed as an expense percentage by looking up the fund’s ticker symbol on any number of online services such as Morningstar, Yahoo Finance and many others.
Advisor support – If you are working with a fee based advisor like Financial Wealth Builders Securities, a comprehensive and holistic financial plan is provided in conjunction with investment recommendations. Fees should be fair and reasonable, transparent and fully disclosed upfront.
Administrative oversight – If you are invested beyond the pale of an individual brokerage account containing funds or securities, expect added costs to compensate for the extra administrative oversight and infrastructure involved. Think retirement plans, separately managed accounts, annuities, hedge funds, Real Estate Investment Trusts (REITs), private equity ventures, and so on. This is a key area where hidden costs can fester. As a result, investors often fail to realize there are added costs involved at all, let alone the extent to which they may exist.
Joining the Cost-Management Movement
As financial professionals, we deserve to be fairly compensated for our efforts. But as an investor, you deserve full disclosures and clear explanations, so you can determine for yourself whether the costs are justified. We look forward to helping you join us and a growing community around the globe as we advocate for the importance of clarifying and controlling investment costs. If we could offer only one piece of advice on the matter, we would conclude by urging you to forever heed this familiar adage: If it sounds too good to be true, it probably is.
Paul Philip is president of Financial Wealth Builders Securities, a team of independent wealth advisors providing holistic financial planning, investments and strategies to well informed Canadians. Visit www.fwbsecurities.com for more investor education and resources.