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%.
Exactly, BG – and taking on more risk than appropriate could be even more damaging to the client than charging them too high an AUM fee (though there are undefined limits on this…they must be “reasonable”) or charging them too many hours. Flat fee isn’t necessarily best either because then the adviser can make more money if he can limit how much time it takes him, so there may be a problem of inadequate analysis. But that’s usually pretty obvious to a client. If the advisor is ignoring you and never has time for you, then you’d want to dump him.
Paul) Interesting, I didn’t realize there were laws / regulations against charging fees on the gains. Not sure what the rationale is, because if this practice were allowed, it practically removes all bias and the investor’s and advisers / fund managers goals would all be aligned.
I guess the downside is that perhaps the adviser / fund manager would take on tons of extra risk to make money…
I think education is the most important word in the blog post. If you really want to make sure everything is working how it should in your favor self-education is going to be important with all investments. People should be prepared to ask a lot of questions about how and where their money will be handled.
In the long run, one percent adds up to a lot of money. Even 0.5% adds up after a couple of decades.
@BG: It’s a nice thought but Registered Investment Advisers are prohibited (by the states & SEC) from charging their fee based on capital gains (realized or unrealized). Only hedge funds are allowed to do this and they even have restrictions on the practice.
@Adam: Good luck finding an AUM adviser who will help you if you’re “just starting out”. Most won’t bother. That leaves you with commissioned brokers or fee-only hourly or flat fee planners.
Fee based advisors have fiduciary responsiblity to their clients. Why would they steer you into more costly investments when they only get the 1% fee. You cannot take 12b-1 fee’s or commissions if you charge a fee per FINRA regulations. So explain why it’d be in their best interest to move you to costly investments?
As far as advisors who charge hourly how often do they rebalance clients portfolio’s? Annually? How quick does the market move and how beneficial is that.
My point still remains on a 60/40 split you’re real cost is less than 1% since advisors have the ability to purchase bonds at a much lower markup than individual investors. The real problem isn’t fee based advisors it’s commissioned brokers.
Adam: The 1% advisory fee is in addition to the underlying investment costs – and as John points out, many advisors will steer you into more costly investments.
I couldn’t agree more that attempting to time the market is a bad idea. And most advisors won’t do any better than individual investors at this.
I wholeheartedly agree that people should index their investments – and if you click through and look at the books I recommended when I encouraged people to educate themselves, you’ll see that’s exactly what they teach.
How about the adviser (and heck fund managers) to only get a cut of the _gains_? As it is now, Wall-Street (and their henchmen the salesmen/advisers) make money whether we do or not.
I second the majority opinion here: go with a flat-fee adviser. But if you are just starting out, perhaps the 1% royalty fee is cheaper until you build up a decent nest egg (do the calculations first).
So let’s say this advisor invests in individual stocks and charges you 1%, or I go buy a typical mutual fund and pay on average 1.2-1.5% or higher. Who comes out ahead? What about clients who buy bonds, advisors get better prices by buying in bulk thus effectively lowering their fee. Isn’t that a huge benefit?
Also you fail to mention that individual investors are notoriously bad at trying to “time” the market. Why not skip all the BS and buy a S&P ETF and just meet the market?
Totally agree, Nickel. This is why I set up my financial planning firm to be fee-only. I offer clients the option of hourly or flat fee depending on their situation and preferences. There can be value in having a financial planner, but a 1% fee every year can be difficult to justify. Plus, they then choose to limit their services only to the wealthy which leaves young people out to the commission guys. Not all of them are bad, but it’s far too easy for them to be swayed by conflicts of interest.
It’s not just the percentage of assets fee. Advisors will often steer you to their own company’s mutual funds, which typically have sales loads and high expense ratios.
I use an advisor for some (25%) of my investments. I like the way he thinks and we have discussions on different investment strategies. His company sponsors dinners several times a year hosting speakers form around the country. I consider his fee a good investemnt in my continuing education.
Fees for handling my money – not for making more with my money – drive me crazy and are the reason why I will always handle my own investments. In order to reduce fees and loads, I use Vanguard and have been really happy with the results/prices.