According to Nobel Prize-winning economist William Sharpe, “The golden rule of investing is diversify and minimize investment costs.” Unfortunately, most investors do not understand the importance of minimizing investment cost. This article fills this critical gap in understanding. For the sake of simplicity and brevity, this article ignores many important nuances, such as our net worth increases during our years of work and reduces during retirement.
Sacrificing 30% of investment over 30 years
Let’s assume that a financial product such as a mutual fund has fees of 1% per annum. The fee appears to be small but, in reality, it isn’t. It’s the mind playing games with us. Giving up 1% per annum over 30 years means giving up a total of 26% of the investment. It requires a pocket calculator to arrive at that 26%.
You can instead use a short-cut to arrive at a rough estimate: 1% per annum lost over 30 years is approximately equal to 1% multiplied by 30 (years) which is equal to losing a total of 30% of the investment. So, the next time, multiply the fee by 30 (years) to understand how much it will cost you in the long term.
Cutting the budget by 30% after retiring
I wrote previously in Mint that a couple X retiring at the age of 60 can spend one-30th or 3.33% of their net worth in their first year of retirement. If they give up 1% of their net worth in investment fees, then their budget for personal expenses for the first year gets reduced to 2.33%. This is a 30% reduction in their household budget.
For example, imagine that couple X are retiring today with a net worth of ₹3 crore. Normally, they should be able to spend 3.33% of ₹3 crore, which is ₹10 lakh during the first year of retirement. However, if they pay investment fees of 1% of ₹3 crore ( ₹3 lakh), then they’ll be left with only ₹7 lakh for their household expenses for the year. This reduction of 30% in their household budget may force them to change their lifestyle like living in a much smaller apartment and affect their goals like preventing them from travelling out of town to meet their children.
Couple X is likely to have already sacrificed up to 30% of their investment due to higher investment fees between the age of 30 and 60. Hence, even 3.33% of their remaining net worth (for example, the full ₹10 lakh mentioned above) may not be sufficient to meet their bare minimum needs. To compensate for that, they may have to postpone retirement by 5-10 years to the age of 65-70, depending on the variables.
Fees are a reality
Couple X may assume that active equity mutual funds will, net of fees, at least match the performance of the index. Their mistake is that fees are a reality, while the higher returns are only a hope that may not materialize. The only correct report that can answer this is the Standard & Poor’s Indices Versus Active Funds (SPIVA) India report (bit.ly/Spivareport). It shows that net of fees, the average Indian active mutual fund generated the same returns as the index and half of the overall equity funds generated lower returns than the index.
International trends indicate that in the future, more than half of Indian funds are likely to generate lower returns than the index over the long term. Further, one may have to wait for 20 years to find out whether a fund manager is able to beat the index. If a fund does not beat the index, the fees of 1% per annum multiplied by 20 years, which is equal to 20% of the investment, is not refunded to the investor.
Zero real returns could become negative
The article mentioned earlier also argues that returns net of inflation (or real returns) and net of taxes are likely to be nil per annum. Giving up 1% per annum in fees may reduce couple X’s net-of-fees real-returns to minus 1% per annum. So, they should think twice about each 0.1% per annum (within direct plans, almost all Nifty index funds charge 0.1%) that they pay in investment fees.
The straightforward way to minimize investment fees is to use index funds and direct plans, which charge zero commission. One should similarly focus on minimizing fees on investment advice but that is a topic for another time.
The financial product with the higher fee should provide you with an extremely strong reason for you to pay that much. Your job is to focus on diversifying and minimizing investment costs and the trade-off between the two. This will prevent you from destroying your own investment returns.
Avinash Luthria is a Sebi-registered investment adviser and advice-only financial planner at Fiduciaries.in