Financial Friday #65: How Much Does 2% Really Cost?
We scrimp and save to fund our RRSP and TFSA contributions and keep a watchful eye on our returns – but why is it that so few people pay much attention to the fees they are paying on their investments?
“It’s only 2%, that’s just a couple of bucks out of a hundred!” Anyone who ever says these words with regard to investment fees has just made a very costly mistake!
Let’s say you are 25 years old and max out your annual TFSA contribution with $6000. Let’s also say you are super busy and have little time to fool around with where or how to invest that money. You stop by your local bank to get some advice and they recommend one of their “top performing” mutual funds.
They dutifully inform you of something called the management expense ratio (MER) built into the fund, and point out that this 2.35% annual fee is “average” for Canada.
This seems reasonable to you, everybody has to get paid and you tip a restaurant server 15%, so this seems like a relative bargain! No one does any math, the whole matter is soon forgotten, and it becomes routine. In fact, you barely notice this built-in MER on your annual statement.
When you are ready to retire at age 60, your $6000 in that “top performing” mutual fund has returned 5% annually and grown into the tidy sum of $14,987.
Little did you know, becoming more financially literate (check out our Wealth Mastery program) and investing in an index fund on your own is dead easy. Your annual fee would have dropped way down to 0.65%, and that is at the top-end, some options are as low as 0.25%!
If we re-do the math with the same parameters ($6K for 35 years at 5%) and use a 0.65% annual fee, you can see that your investment would have grown into the much tidier sum of $26,631!
Doing some much more simple math ($26,631 minus $14,987) reveals that your retirement fund has $11,644 less than what it should have.
But wait…. how can a mostly set-and-forget index fund return the same as a highly managed “top performing” mutual fund? The answer is that index funds often match or outperform “managed funds” with much higher fees regardless of whether the market is stable or volatile.
You can always find exceptions and some advisors may have success over a couple of years. However, very few are consistently able to beat the index over the long term. When you factor in low cost and ease of maintenance, the decision is a no-brainer for most investors. You can learn all about index funds and trying to beat the market here.
If math is not your strong point, this online tool instantly shows how fees cut into your investment returns (we used it for the above examples). It was created by Larry Bates, a DIY investment guru who quite literally wrote the book on cost-effective investing for Canadians.
If you want to learn more about saving on your investments, you are in luck! Larry will be joining us next week and sharing his best tips in a FREE webinar.
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