#HowToInvestWell Stage Five - Costs
Do you really know how much you are paying for your investments?
It is an important question because when returns on cash are low, returns on other types of investments also tend to be lower too. In this environment, costs are like grains of sand slipping through your fingers, you are only left with what you can hold onto.
Financial services has often been accused of being opaque and we have all heard examples of poor behaviour and the down right criminal. It can therefore be hard to be sure when it comes to the real cost you are paying for an investment.
There are two types of cost, the ones you can see and those that are hidden. These include the following:
- Annual Management Charge - the fee you pay direct to the primary investment manager(s) for managing your investment risk
- Underlying investment costs - the cost of operating the portfolio or fund, including third party fund managers fees, administration costs and taxes. Funds are obliged to publish the total cost of the fund (known as the Total Expense Ratio, or Ongoing Charges Figure). However, if your money is not managed within a fund, this is not always disclosed
- Initial set up, dealing, exit or penalty fees - the charge made for executing investments on your behalf or
- Spread - The difference between the buying and selling price of an investment
- Platform or custody fees - The charge made for holding your investments and administering them annually
- Advice / Service fee - Any charge for providing you with personalised advice or service, be it financial planning or investment related
- Others - Some firms also charge you for making payments, producing tax reports and managing other aspects of your day to day finances. Some even charge you an inactivity / minimum fee because you haven't done anything or your portfolio is lower than their minimum threshold
Some well known investment managers are evasive when it comes to explaining how they make their money and this should be a red flag for an investor.
Some institutions also pride themselves on having an exclusive brand, with have marble lined offices and other signs of excess. As with any luxury good or service, there is no intrinsic value or guarantee that the more expensive option will do a better job. Many entrepreneurs or self made clients I speak to feel that this is not in keeping with the world we live in and believe that parts of the industry have lost touch. It is a sign that they have forgotten who's money it is after all and ultimately, it is the client that is paying the price.
It is part of the reason why many people have lost trust in the banks and other once revered institutions.
Why is it so important?
When a typical portfolio of bonds and equities is only likely to generate around 6% each year before fees, any fee you are paying is going to reduce your net return. To put that into context, if you are paying more than 1.5% each year for your portfolio, you are effectively giving up more than a quarter of your annual return. Doesn't feel great does it...
If you look at this over a longer period, it means you are giving up thousands of pounds each year and this can really build up over time. Over the course of your life, the figures are eye watering.
Let's look at a simple example. Imagine you have £100,000 and you managed to save £200 pm every month for 30 years. That's a total of £172,000 you would have saved.
Now imagine you invested that in a portfolio that generates around 6% each year before fees or charges are applied. The impact of different charges on your net return for the same portfolio can be seen below:
The impact of different levels of annual fees over 30 years
This is an illustration and do not take into account market volatility on an annual basis or inflation and is not a projection of what your investments will be worth. Remember the value of investments can fall as well as rise so you could get back less than you invest.
It is therefore important that charges are considered as part of the overall strategy, as the effect is dramatic. It could mean the difference between meeting your objective, or not, like having enough money for a comfortable retirement.
"As in business, long term investing is about making a commitment to a process and a strategy, not speculating. The only thing you can therefore truly control is your costs, so start there." - Andrew McCulloch
It is therefore worth spending time to truly understand what you are paying for and how much each element costs. If your current provider cannot explain this simply, both in percentage terms and in pounds and pence, it might be time to change.
Cost alone shouldn't be the primary driver of your decisions, as it is much more important that you are getting value for money.
Costs and charges should be as transparent as possible and reviewed regularly, as they should reflect the value delivered to you the customer.
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