Paying lower fees directly can be tough on investors
Psychology plays a big role when it comes to money and especially investing. Most of us know we are supposed to BUY LOW, SELL HIGH to make money so why is it that over and over again people do the opposite. When things go down, they panic and want to sell or want to make the portfolio more conservative. It’s because of psychology.
Fees can also influence psychology and investor behavior.
About 5 years ago, Mark moved from mutual funds with a 2.5% embedded management fee (management expense ratio) to a discretionary account where he is paying 1.25% per year on a $175,000 account. At first glance, it appears that Mark saves about $2200 per year in fees or $11,000 over 5 years.
Unfortunately for Mark, he does not see this $2200 per year savings. Instead, all he sees is a bill for $2200 per year.
Mutual fund fees are imbedded
When Mark was invested in mutual funds, he was paying 2.5% in fees per year but he never saw that directly. Even though he was paying a whopping $4375 per year in fees on his $175,000 it did not feel pain because he never saw the money go out.
When he got his statement, any returns he got were posted net of fees because the mutual fund company is regulated to do so.
If Mark looked at his statement 5 years ago and saw a 7.5% return, that means the actual return before fees was 10% but after the 2.5% fee was taken off, he was left with a 7.5% return.
Discretionary fees are paid directly
After 5 years of poor performance, he is tired of paying a $2200 fee per year to breakeven.
Even though paying a 1.25% fee is lower than an imbedded fee of 2.5%, it can be more painful because you can see the fee going out.
Mark asked me for my advice because another mutual fund salesperson was now courting him to go back to the world mutual funds where he does not have to pay the fee directly. Even though he would pay more in fees, he was considering this suggestion.
Lower fees are better
Even though it may be more painful, the general rule of thumb is lower fees are better. If you pay less for a product or service, you will have more money in your pocket, right? Although this concept may appear to be pretty straightforward, it does not seem to resonate with investors.
Just take a look at this simple view of fees
My two cents
Psychology plays a big role in investing and Mark’s conundrum is a perfect example of how emotion and psychology can win over logic. One of the easy solutions is for the mutual fund industry to start being more transparent when it comes to the fees. One of the bloggers I read regularly, Michael James on Money suggests that investment companies should move to disclose the impact of fees over the long term through an acronym he calls MERQ (as opposed to MER). Basically it shows how much of your portfolio would be consumed by fees over a 25 year period. He uses the example of an Investors Group Fund with an MER of 2.89% which would have a MERQ of 51.4% (Yes, that means an MER of 2.89% means 51%of the portfolio would be consumed by fees over a 25 year period). Would this help investors?
Credit card companies now must show how long it takes to pay off the credit card based on the minimum payments. Mutual fund companies should show the gross gain or loss in a year, the fees paid by the fund and the investors’ net gain or loss.
Investors deserve to know how much they are paying in fees and although one might argue they can find out the fees and do the calculations themselves, Mark’s situation is a perfect example of why we need more detailed disclosure on the statements.
What do you think needs to be done to help investors be more aware of the fees they are paying on their investments?
You’re right about visibility of fees making a big difference because of investor psychology. Thanks for helping to popularize MERQ. Most mutual funds would have little interest in MERQ, but that doesn’t have to stop the rest of us from using it.
In Australia Financial planners are being re-reviewed due to the way many of them have structured their fees. Personally, I think this is a good thing for retirement planning and especially for investors.
I think any fee structure needs to be transparent to a client and when you have some financial planners collecting money each year (passive income) while losing a clients money and without even seeing their clients from one year to another, does need the brakes put on these businesses.
Personal rates of return for each account would also be a BIG help for retial investors. Regulators seem to avoid this issue – I wonder why.
Nice breakdown of the elements. I just recently got my credit report and am going through the details now! Core Logic sounds like it is definitely going to invade my personal space!
Cool post. I’ll keep this one in mind because I’m looking to run a business soon. I’m ready for the challenge, but I can still use all the help and advice I can get. Lately I’ve been thinking about buying a business instead of starting one from scratch. Maybe a franchise? I’m not sure. Any suggestions? Advice? Thanks!
If it flies ,flouts ,or Advice …pay per hour
I must say that I am a victim of fees. And now, all I can suggest is being financially literate. Research properly before making any financial decision, and get more then one opinion regarding any choice you need to make. Thanks Jim for pointing this out in a very visual article. Sometimes it takes seeing something drawn out to better understand it!