As a long-term individual investor, it’s smart to keep investment fees (management fees, expense ratios, load fees, taxes, etc.) to a minimum to keep more money in your portfolio compounding over time to make you richer.
In fact, paying “just” a 1% investment fee will cost you millions of dollars throughout your investing lifetime.
In this day and age, there is no reason to pay an exorbitant amount of fees through actively managed investments when there are more efficient, lower-cost index funds (and ETFs) available for a fraction of the cost that can be bought and sold with no trading fees and commissions.
The best part is you can easily manage your own passive investment portfolio of index funds for free through any brokerage of your choice without the need for an expensive financial advisor charging you another 1%+ investment fee on your portfolio!
If you are saving and investing for your financial freedom and the ability to live your ideal early retirement lifestyle, there is no reason why you can’t manage your own investment portfolio, using a passive investment strategy with extremely low-cost and simple-to-manage index funds.
In addition to much lower fees, tax efficiency, trading costs, and ease of buying and selling, history has proven that a passive investing strategy outperforms an active stock-picking strategy the majority of the time, making it the 80/20 investment option for most investors.
Hence, playing the index by paying lower fees and getting higher returns will make you millions of dollars richer!
Investment Fees Matter, A Lot
While a 1% fee might sound small, it’s extremely costly to your portfolio over time.
Paying “just” a 1% expense ratio on a $1 million actively managed portfolio is $10,000 a year in fees EVERY SINGLE YEAR, regardless of the fund’s performance.
Add to that an investment advisor that charges a market standard 1% fee on assets under management (AUM) and now you are paying $20,000 a year in investment fees alone.
If you hit Fat FIRE with a $10 million portfolio, the last thing you want to do is spend ~$200,000 a year on investment fees that could be spent on living your best early retirement life!
In contrast, an index mutual fund like VTSAX (Vanguard’s Total Stock Market index fund) or ETF like VTI (Vanguard’s Total Stock Market ETF) has a 0.03% expense ratio or just $300 in annual fees for every $1 million invested.
In addition, it’s simple to self-manage your own portfolio of index funds (and ETFs) for free, buy and sell with no commission or load fees, and reduce your total investment expenses to a fraction of the cost.
If you’re a high earner who’s worked hard to build a $10 million portfolio, would you rather pay ~$200,000 a year in fees for an actively managed portfolio or ~$3,000 for a simple passive investment strategy with better chances of higher long-term returns, tax efficiency, and ease of buying and selling?
It’s a no-brainer for most financially savvy people.
If you do require or want professional investment advice at some point, avoid investment advisors that charge a percentage fee based on AUM.
Instead, opt for a financial advisor that charges a flat annual fee (regardless of portfolio size) if you need continuous professional management or a one-time fee for portfolio analysis and investment advice.
A “Small” Investment Fee Can Cost You Millions
To show how a 1% investment fee can cost you millions, let’s take a look at a hypothetical HENRY.
Henry is a 30-year-old who has a $1 million investment portfolio invested in stock index funds and plans to coast into retirement over the next 30 years.
Assuming he never contributes another dollar to his investment portfolio, at a market average 7% real rate of return, he would have ~$7.6 million by the time he plans to retire at 60.
That’s ~$300,000 a year to spend if he follows the 4% rule. Pretty good!
If he instead held an actively managed investment fund with a 1% expense ratio, his net return would drop to 6% and he would end up with ~$5.7 million instead.
That seemingly insignificant 1% annual fee costs him ~$1.9 million or ~25% of his overall portfolio.
Lastly, if Henry also has a financial advisor who charges a typical 1% AUM fee on top of his actively managed fund’s expense ratio, his net return would drop to 5% and his portfolio would plummet to $4.3 million.
Think about that – the seemingly small 2% fee that Henry can eliminate from playing the index saves him from losing $3.3 million or ~43% of his wealth!
Add on top the higher taxes and potential load fees, and you quickly see how poor of a tradeoff active investing becomes.
Index Mutual Funds Versus Index ETFs
On the subject of index mutual funds (i.e. VTSAX) versus their respective ETFs (i.e. VTI), while they are both great options with very low expense ratios, there are slight advantages to each depending on your personal preferences.
With an index mutual fund like VTSAX, the main benefit is you have the ability to set up automatic investing for a set amount that gets taken from your bank account at preset dates. This makes it easy to use as part of your money system for automated investing.
With an index EFT like VTI, the main benefits are portability (i.e. ability to transfer brokerages) and slightly better tax efficiency (vs. non-Vanguard index funds). ETFs are just like stocks so it’s easy to transfer between brokerages or gift to other people without having to liquidate your investment and incur any capital gains taxes.
Personally, I prefer using ETFs with the benefit of portability at the expense of spending a few more seconds to manually make investments every month. In addition, commission-free trading and fractional shares make it easier than ever to buy and sell index ETFs freely.
At the end of the day, both index funds and ETFs are great, low-cost investment options with negligible differences.
Choose if you prefer having portability or automatic investing and don’t overthink it.
Higher Fees Do Not Generate Better Returns
In general, if you’re paying a premium for something you expect better quality, better service, and better performance.
Unfortunately, in investing, higher fees do not offer better returns. There are numerous studies done that show the higher fees from active investing do not generate better returns than low-cost passive investing. In fact, they are on average worse!
Since 2002, S&P has published an annual S&P Indices Versus Active (SPIVA) scorecard which provides a comprehensive and unbiased analysis of active versus passive investment performance.
The data shows that the majority of active investment managers, regardless of asset class or investment style, failed to meet or exceed their respective passive benchmark indexes.
In the first half of 2023, ~60% of actively managed large-cap funds underperformed the S&P 500 over a 1-year horizon.
These underperformance rates rise significantly over a longer time horizon, with more than 90%+ of actively managed funds underperforming the S&P 500 index after 15 years.
So not only are you guaranteed to pay millions in exorbitant investment fees over time, but your investment returns are most likely going to be lower than if you had just played the index!
Double whammy, ouch!
Win The Investing Game: Stick To Simplicity And Avoid Making Mistakes
Looking at the historical data, it’s certainly possible to beat the index over a short time period (one, two, or even three years), but the odds of consistently beating the market over decades are extremely small and you’ll most likely be far richer by playing the index.
Logically, in order for an active investment manager to beat the market on any given year, they must be able to cover the market return, their own management fees, commissions, and other expenses. Hence, active investing is a “loser’s game.”
Sticking to a simple passive investment strategy that focuses on avoiding mistakes such as paying high investment fees, trading in and out of the market, incurring high tax liabilities, etc. will give you the best odds of winning the investing game.
For this reason, building an investment portfolio using low-cost, tax-efficient, and easy-to-manage index funds and staying invested over the long run is the 80/20 strategy to build wealth in the long run.
Of course, you can attempt to pick your own stocks to try and hit the next unicorn like Facebook, Amazon, or Nvidia, but do it with a minority of your overall portfolio, and don’t spend too much of your precious time trying to beat the market if professional investing is not your day job.
Setting the majority of your investments on auto-pilot will allow you to focus your time and energy on important things such as improving your health, increasing your income through your career and business, and experiencing life.
Playing the index will allow you to build wealth through the stock market and save millions in investment fees and expenses while freeing up time to live your best life.
That’s a winning strategy to me.