Broke and Broker (part 2)
This week I received a comment pointing out that broker’s commissions have changed a lot since the time of my week at Suze Orman’s Merrill Lynch.
That’s very true! Over the past couple decades financial advisors have switched to charging general advisory fees rather than taking commissions on sales of financial products to customers. Creators of mutual funds also charge fees now instead of using commissions.
But do you know how much those fees will really cost you over time?
Broker and mutual fund fees – how much are they?
Financial advisors typically charge from from 1 to 2 percent of your total assets per year for providing you with their services.
If you are a DIY investor, you’ll choose to buy mutual funds directly from the fund creator, through a “supermarket” brokerage such as Charles Schwab, or from an online brokerage such as E-trade. But you’ll still pay fees on your fund. The range for these fees is similar to those you’d pay a broker, although a few mutual fund creators, such as Vanguard, do operate at a fraction of this cost.
You don’t usually see fees once you buy a broker’s services or a mutual fund. The fees are periodically taken out of your account. And most investors don’t pay much attention to such fees. After all, 2 percent seems so little.
But it isn’t. Not really.
The magic of compound interest
Most of us have heard of compound interest. We see our savings account grow interest on monthly, quarterly or daily basis. We know that compound interest is interest paid on interest already accrued for as long as you save or invest.
For example: At ten percent over two years, the annual interest paid on interest from one dollar is 1 cent interest paid on 10 cents interest paid on a dollar investment. That totals $1.11 As you keep on earning compound interest for 9 years, according to the Rule of 72 (see *note below) your dollar doubles. You’ll then have $2.
Over the years, the way compound interest “grows” your money seems like magic!
The real cost of a 2 percent broker or mutual fund fee
Most of us have heard about about compound interest. What most of us haven’t heard about is that compound interest can also grow the other way: more and more “minus” instead of more and more “plus.”
Broker and mutual fund fees “earn” compound Interest too. For you that means there’s a “minus” compound interest that’s deducted from your investment account.
Take a look at the chart below. It shows how much an investor makes annually at 8 percent on an investment of $1,000 for over 50 years. The columns show how much you get after three different levels of fees are taken out. The three levels of fees are: zero, one percent, and two percent.
You can see the results. “No fee” taken out results in $50,653.74 in 51 years. That amount is your 100 percent return on $1,000 dollars compounded annually at 8 percent. $50,653.74. Quite a nice sum!
Now take out a “2 percent fee.” That results in a total sum of $18,077.63. In other words, at the end of 51 years, you’ll receive only 36 percent of the whole amount your $1,000 investment earns! Even a puny fee of 1 percent results in your receiving only 60 percent of what your money earned.
Who gets the rest? Your broker and/or your mutual fund company.
CHART: Mutual Fund Fees and Earnings over 51 Years at 8%
* Rule of 72 for estimating how long it will take to double an investment earning compound interest: for $1,000 at 8 percent interest per annum, divide 72 by 8. That tells you you’ll need roughly 9 years for your investment to double to $2,000.
Copyright © 2010 Nancy K. Humphreys All rights reserved. You are free to use material from Brucenomics in whole or in part, as long as you include attribution to Nancy K. Humphreys followed by a live link to http://www.brucenomics.com.
Next time: why a 1 or 2 percent fee seems so little – the mutual fund prospectus