Wednesday, September 21, 2022

Keeping Investment Costs Low Matters

“If returns are going to be 7 or 8 percent and you're paying 1 percent for fees, that makes an enormous difference in how much money you're going to have in retirement.”

- Warren Buffett

As an investor, I believe that long-term success is dependent on actions within my control. Namely these include:

1) Ability to select and stick to a strategy
2) Ability to invest regularly, through thick and thin, and not timing the market
3) Ability to diversify and not put all eggs in one basket
4) Ability to keep investment costs low

Today, I will focus on the fourth point, which is keeping investment costs low.

This is fairly easy today at least for US investors, because most brokers offer commission free investing. It has never been easier to buy into some of the worlds best companies, and share in the success of these enterprises in the form of higher dividends and higher share prices over time. It is fairly easy to set up a diversified portfolio as well.

When you keep investment costs low, this means that you have more money working hard for you.
If you pay a mutual fund or an investment adviser 1% per year on your investments, this means that you are losing out on future compounding of this money. To add further insult to injury, that 1% of assets under management is a recurring fee that is paid every year. In addition, that money would have compounded over time as well, which makes this cost an even bigger one. Paying a fee is equivalent to another tax on your dividend income.

For example, if you invested in Johnson & Johnson (JNJ) today, you would generate a yield of 2.75%.

However, if you paid me a 1% fee each year on net worth, you are essentially paying a 36% tax on your dividend income, in addition to paying taxes on dividend income. This exercise assumes you are using a taxable account.

Let’s run some numbers. If a stock delivers a total return of 7%/year over the next 30 years, it would turn $1,000 into $7,612.25. A total return of 7%/year could assume a starting yield of 3% and annual growth of 4%, compounded over time.

If you paid someone 1%/year to select these companies for you, your annual return is reduced to 6%/year. You are coming up with all the capital at risk, but the other party is coming up with all the ideas. It is possible that they have convinced you to invest intelligently, and that otherwise you may have been keeping your money under the mattress or in a savings account yielding 1% - 2%/year.

Either way, when you compound $1,000 at 6%/year for 30 years, you are left with $5,743.49.

That’s a difference of $1,868.76 over a 30 year period. If we make the period longer, the total lifetime cost will only get larger.

That’s why I believe that keeping investing costs low matters – because that way you have more money working hard for you to achieve your investment goals and objectives.

I actually believe that investing through a Roth IRA is a very good method to reach the full compounding potential for this portfolio, particularly for someone in the accumulation phase.Taxes are a highly personal matter however. While a Roth IRA may be perfect for one individual, a traditional IRA may be better for another individual who needs to keep their Adjusted Gross Income below certain levels (to qualify for tax credits or subsidies on healthcare insurance premiums) OR individuals who expect to be in lower tax brackets when they retire.

Let’s assume annual total returns of 7%/year, with 3% of that coming from dividends, and a 15% tax on qualified dividend income. This means that our total returns after tax end up being 6.45%/year. When we calculate the numbers, we end up with $6,708.16 after compounding an initial stake of $1,000 at 6.55%/year over a period of three decades. That’s $904.09 less than the 7% gross annualized returns available to investors during that time period.

You can see that it would be foolish not to take advantage of a tax deferred account such as a Roth IRA. I thoroughly encourage everyone who is able to contribute to a tax-deferred account to do so.

But they do need to speak with a tax professional first, because everyone’s individual circumstances vary.  In my working career, I have tried maxing out all retirement accounts I was eligible for, including but not limited to 401 (k), H S A, SEP IRA, Roth IRA to name a few.

There may be reasons why someone may not be using a retirement account. Some may not be eligible for them because they do not have employment income or they earn too much to contribute to one without having to go through hassles. A small group may not want to deal with retirement accounts, because they do not know enough about them. They also do not want to deal with complications. That may be an expensive lesson that could force them to work longer than needed to reach their goals and objectives. Or they may be just wrong, and choose to remain ignorant out of spite.

Relevant Articles:

- How early retirees can withdraw money from tax-deferred accounts such as 401 (k), IRA & HSA
Use these tools within your control to get rich
Why Holding 100% of Equity Investments in Taxable Accounts is a Mistake
How to buy dividend paying stocks at a 25% discount
Taxable versus Tax-Deferred Accounts for Dividend Investing

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