It is difficult if not impossible for a small investor (<$250,000) to get a financial investment advisor. The advisor simply cannot afford to spend their time on such a small account.
If you have less than $250,000, most Banks, Life Insurance companies and Investment Advisors will be steering you to their company’s Mutual Funds, which typically charge fees in excess of 2% per year.
Now 2% per year may not sound like much, but beware.
Let’s explore two scenarios that clearly show how much that teeny, tiny, little 2% per year fee can cost you!
Thelma just inherited a lump sum of $10,000 and opened a joint account with Louise.
They decide to invest the money for 40 years in an all-equity portfolio through which they can earn a long-term average return of 7% per year, but since this is the only money they have to invest, no investment advisor will talk to them.
Thelma has a friend Betty Sue that just started selling Mutual Funds. Betty Sue is super-duper nice and says she has access to a Mutual Fund that only charges 2% per year, 15% less than the typical Canadian Equity Mutual Fund fee of 2.3% per year. Thelma & Louise are thrilled at the reduced fee and embark on their investing career.
Let’s see the impact:
Thelma’s and Louise’s one-time investment of $10,000, earning 7% per year for 40 years, would grow to $149,745, for a gain of $139,745.
However, the 7% return is reduced by the 2% per year Mutual Fund fee. As a result, Thelma and Louise only make 5% per year, (i.e. 7% - 2% = 5%) on their investment.
After the Mutual Fund fee, Thelma and Louise’s one-time investment of $10,000 is earning only 5% per year for 40 years, and will grow to only $70,400, for a gain of $60,400.
Betty Sue's teeny, tiny, fee of only 2% per year has just cost Thelma and Louise $79,345, ($139,745 - $60,400 = $79,345).
In other words, the 2% per year Mutual Fund fee, cost Thelma and Louise 57% of the gain on their investment, (i.e. $79,345 / $139,745) = 57%.
Yes, it’s true, that teeny, tiny, little Mutual Fund fee of 2% per year fee, cost Thelma and Louise 57% of the gain on their investment!
Now the investment world can be a bit confusing, so let’s examine a world that is a bit more familiar.
Let’s see how a 2% per year fee would equate to a realty commission on the sale of a house after 40 years of ownership, (a creative approach introduced by Larry Bates, author of Beat the Bank).
Strange concept I know but stick with me.
Let’s say Thelma and Louise bought a small house or condo in the suburbs for $500,000 when they both turned 30, and they stayed in that house for 40 years.
Assuming modest 2% per year house price inflation means Thelma & Louise’s $500,000 house is worth $1,100,000 when they reach age 70.
At age 70, Thelma & Louise are thrilled with their house profit windfall and they both decide to sell the house, travel the world until the money runs out, and then drive off a cliff, (for younger TheAnswerIs.ca readers, google “Thelma and Louise”).
The first real estate agent Thelma & Louise contact says she can sell their house for $1,100,000, and that the realty commission will be 5%, equating to $55,000.
Thelma and Louise are horrified that they must give up $55,000 of their $600,000 gain on their house to pay the realty commission, so they decide to get a second opinion.
Thelma & Louise then reach out to their old friend, Betty Sue, the young girl that sold the Mutual Funds to Thelma & Louise. Betty Sue has just embarked on a second career as a Real Estate agent.
As Thelma and Louise would be Betty Sue’s first real estate customer, Thelma and Louise feel they will get a discount on the commission, because they are effectively launching Betty Sue’s new real estate career.
Betty Sue is thrilled with the opportunity, and after doing her market research also feels she can get Thelma and Louise a sale price of $1,100,000 for their house, before commissions.
Thelma and Louise are satisfied with the sale price estimate and ask Betty Sue how much commission she will charge.
Betty Sue, as a previous Mutual Fund salesperson, figured that she would simply calculate her commission based on the cost Thelma and Louise incurred for their Mutual Funds for the last 40 years.
With a straight face, Betty Sue says her realty commission will equate to 57% of the gain in the value of Thelma and Louise’s house or $342,000, (($1,100,000 - $500,000) * 57% = $342,000).
Thelma & Louise are indignant!
Betty Sue is surprised at Thelma and Louise’s indignance!
Thelma collected herself and in the calmest voice she could muster, asks how Betty Sue came up with a $342,000 realty commission.
Betty Sue, quite confidently says, "well you were willing to incur a cost equating to 57% of the gain you made on your Mutual Funds over the last 40 years, so I just figured that you would be happy with the same amount when selling your house".
Thelma and Louise put Betty Sue in the car………
You wouldn’t pay a real estate commission of 57% of the gain of the value of your house, so why do it with your Mutual Fund investments?
Are you unsure what your Mutual Fund salesperson or financial investment advisor is charging you and want to find out how to ask the question?