You’ve heard time and again that expenses matter when it comes to investing. In fact, when it comes to mutual funds, Morningstar has gone so far as to argue that “investors should make expense ratios a primary test in fund selection… In every single time period and data point tested, low-cost funds beat high-cost funds.”
This begs the question…
If expenses are so important, then why are so many people so quick to fork over a ton of money to an investment advisor? The “assets under management” model, where an advisor collects a percentage of the funds that they’re managing, has become increasingly popular. Typically, this fee is around 1%.
The high cost of 1%
While that might not sound like a lot, 1% can have a huge impact on your investment returns. Consider, for example, a hypothetical investment portfolio with an initial value of $250k. In this case, the investor doesn’t have a huge tolerance for risk, so he dials in a nice 60/40 split between stocks and bonds.
If we assume that, over the next 30 years, this portfolio averages 6% annual returns, our investor friend would be sitting on over $1.4M. If, on the other hand, they had turned over their portfolio to an advisor charging 1%, and if that advisor (in accordance with the investor’s risk tolerance) had assembled a similar 60/40 portfolio, it would be worth less than $1.1M after 30 years.
This is a difference of more than $350k – all because of that pesky 1% annual fee.
Of course, you could argue that the advisor would do a better job of managing that money, thereby offsetting the higher cost. And while I do agree that good financial advisors can add value, it’s rarely enough to come close to offsetting a 1% fee.
Sure, there might be a rare advisor who can significantly outmaneuver the market, but what are the odds that you just happened to connect with one of them?
Effects on retirement income
Still not convinced? Let’s fast forward to retirement… If we assume that a particular investment allocation is sufficient to provide you with a (say) 4% safe withdrawal rate, then an additional 1% advisory fee means that your advisor is getting a quarter of your retirement income.
Read that again. For every four dollars of spendable income that your portfolio generates, your advisor will get one of them. That’s huge. So do yourself a favor and get educated. Read some books about investing. Take a course (or two) at a local community college. Then read some more books about investing.
From there, it’s just a matter of putting your newfound knowledge to work.
An alternative approach
If you’re still not comfortable with an entirely DIY approach, keep in mind that there are financial advisors out there who will assemble a plan for an hourly rate. From there, you just need to implement it. Open an account with a trustworthy outfit like Vanguard or Fidelity, spread your existing funds into your target allocation, set up auto-investments for ongoing contributions, and rebalance as necessary.
Yes, it really is that simple. And if you ever feel like you need a checkup, you can pay for another hour or two of your advisor’s time on an as-needed basis.
If you’re still overwhelmed, you can always invest in a target-date mutual fund like the Vanguard Target Retirement series. While I’ve criticized these sorts of funds in the past, they’re generally a solid option for new investors who are just getting their feet wet – and you don’t have to fork over an extra 1%.