You’re Being Fooled Into Overpaying For Underperformance – Here’s How

When people ask me what I do, I tell them I’m in the business of helping people make money. The business we’re really in though, is helping improve the lives of our clients. It comes from the belief that life is about more than money. I believe money is an enabler – it provides us with options, choice, and flexibility. So if we can help our clients preserve and build their financial wealth, we can help them live a more meaningful and fulfilled life – a life that is truly rich.

Sadly, most people never achieve a life that is truly meaningful and fulfilling – true wealth. Why? Because they’re focused on the scoreboard, and not the process. They’re focused on chasing the money.

Enter the world of investments, stock brokers, financial advisers, fund managers, and high flying financial institutions. If you’re not careful, you might be sailing toward financial freedom with a hole in the bottom of your boat. That hole, is in fact lining the pockets of those purporting to be helping you sail toward the sunset.

When was the last time you looked at your superannuation or investment portfolio statement? Your portfolio has probably grown, especially over the last ten years, so you haven’t taken too much notice. The real question is, how much have you left on the table?

Australians have around $2 trillion sitting in superannuation, which has attracted fund managers like bees around a honey pot. And Australian are paying some of the highest fees for the management and oversight of this money. In fact, last year, Australian’s paid $31 billion in superannuation fees – totaling around $230 billion in the last decade.

So what can you do about it? Here are three things to consider:

1. Fund Fees

When it comes to truly understanding the cost of your investments, it’s hard enough for the professionals to do, let alone the general public. There are many hidden costs that lie beneath the surface – here they are (average):

1. Expense ratio – 0.90% pa

This covers marketing and distribution cost, as well as the management of the portfolio. Typically, this is the only fee investors are aware of.

2. Transaction costs – 1.44% pa

Typically investment managers buy and sell frequently. And with these transactions comes transaction fees. There are three types of transaction costs: 1) brokerage, 2) market impact, and 3) spread.

3. Cash drag – 0.83% pa

This is the portion of your portfolio that is invested in cash. It hurts your return over the long-term because of the missed opportunities in the market.

5. Taxes – 1.00% pa

When you by into a fund, sometimes you’re being taxed for other investors’ gains.

The total of these fees can be as high as 4.17% pa. Although on face value these fees don’t seem high at all, when you compound these costs over long periods of time, it will blow your mind. The above list didn’t even include performance fees!

Here’s what happens when you invest $100,000 into the market with a 7% pa return. The compounding value over 50 years is almost $3,000,000! Let’s start deducting some fees from this return – here’s what you’re left with when you take 1% and 2% in fees:

Even a small number like 2%, compounded over a long period of time, can lead to financial ruin. Jack Bogle, the founder of Vanguard once said:

You put up 100% of the capital, you took 100% of the risk, and you got 33% of the return!

2. Chasing Performance

Forget fees. Just invest in the top performing funds, or sell before the market falls and buy before the market rises (market timing). Easier said that done.

A) Chasing the top performers

Over the last 15 years, almost 80% of all Australian fund managers have failed to beat the broad Australian share index. And after 15 years, only 56% of Australian find managers survived.

Over the last 15 years, almost 90% of all international fund managers failed to beat the broad international share index. And after 15 years, only 46% of international fund managers survived.

B) Timing the market

Researchers Richard Bauer and Julie Dahlquist examined more than a million market-timing sequences from 1926 to 1999. Their research concluded that by just holding the broad market index outperformed more than 80% of market-timing strategies.

Clearly, neither of these strategies put the odds firmly in your favour. In fact, they’re akin to gambling more than anything. Making money in the markets is tough. So if you can’t beat the market by hiring the best, what to the the real experts recommend you do?

3. The Advice

Making money in the markets is tough. The brilliant trader and investor Bernard Baruch put it well when he said:

If you are ready to give up everything else and study the whole industry and background of the market and all principal companies whose stocks are on the board as carefully as a medical student studies anatomy – if you can do all that and in addition you have the cool nerves of a gambler, the sixth sense of a clairvoyant and the courage of a lion, you have a ghost of a chance.

Jack Bogle says understand that what appears to be success in financial markets could just be dumb luck:

If you pack 1,024 gorillas in a gymnasium and teach them each to flip a coin, one of them will flip heads ten times in a row. Most would call that luck, but when it happens in the fund business, we call him a genius!

Warren Buffett wrote this in his 2013 letter to Berkshire Hathaway shareholders:

My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers

He even made a bet in 2008 and put his money where his mouth was. You can read my note about it here.

It’s super important to know that not all costs are bad. The right financial adviser can help you make better decisions over the long-term to save you money. Vanguard recently published a study to help quantify the value of a good adviser.

1. Suitable asset allocation – 0.75% pa

2. Cost effective implementation – 0.70% pa

3. Rebalancing portfolio – 0.37% pa

4. Behavioural coaching – 1.50% pa

Total – 3.32% pa of value added

This does not include any other benefits or value of a good financial adviser, such as strategic and structural advice. Compound that and see what your portfolio looks like.

Next time you pick up your investment portfolio statement, think twice about what you’re doing. Are you 100% sure the financial odds are firmly in your favour? Fees are the silent killer in your portfolio, and only a handful of funds beat the market consistently and over the long-term, and much of this can be attributed to randomness.

Being in the market, while minimising costs, can empower you to getting the real financial freedom you deserve.

Source: Forbes – The real cost of owning a mutual fund 2011, Visual Capitalist, Vanguard, SPIVA, Berkshire Hathaway Shareholder Letter 2013