In his 2017 letter to shareholders, Warren Buffett recounted the first investment he ever made at the age of 11. He wrote(emphasis mine),
“On March 11, it will be 77 years since I first invested in an American business. The year was 1942, I was 11, and I went all in, investing $114.75 I had begun accumulating at age six.
What I bought was three shares of Cities Service preferred stock. If my $114.75 had been invested in a no-fee S&P 500 index fund and all dividends had been reinvested, my stake would have grown to be worth (pre-taxes) $606,811 on January 31, 2019. That is a gain of 5,288 for 1.
Meanwhile, a $1 Million investment by a tax-free institution of that time- say, a pension fund or college endowment- would have grown to about $5.3B.
Let me add one additional calculation that I believe will shock you;
If that hypothetical institution had paid only 1% of assets annually to various “helpers,” such as investment managers and consultants, its gain would have been cut in half to $2.65 Billion.”
That’s what investment costs like brokerage fees, management fees, and transaction costs cumulatively do to your portfolio.
People worry too much about how inflation affects their investments and worry too little about how investment costs affect the returns of their portfolio.
But I won’t blame them. Most don’t understand why and how these costs are even put in place. For example, if you look at most companies offering investment products like hedge funds, balanced funds, or money market funds, most of them don’t reveal their management fees.
They want you to invest with them, but they will not caution you of their fees.
But I’ll also not blame them since even cigarettes and alcohol have precautionary messages like “Excessive consumption of alcohol is harmful to your health, yet people still drink like their life depends on alcohol.”
How Investment Costs Kill Your Portfolio
If you are familiar with the fitness industry, you must be aware of the ever-heated debate on exercise vs nutrition.
The argument has one camp saying that you should focus more on exercise and less on your diet if you want to either reduce your weight or bulk up.
The other camp says otherwise.
Both camps are true, but one is more accurate.
The same case with investment costs. If you only focus on returns and not focus on costs, your net returns over the long term will be in danger.
As Warren Buffett shared in the letter to shareholders above, a 1% increase in investment costs can reduce your returns by half or even more over the long term.
That’s only 1%. What about 5% or more?
As Jason Zweig famously wrote,
“Over the long term, the miracle of compounding returns is overwhelmed by the tyranny of compounding costs.”
That 1% investment cost may look minimal today since you only have a little money invested. Over time, your portfolio will hit 6,7 figures and that 1% difference will be huge if not well taken care of.
Moreover, investment costs also compound. Hence, you are increasingly reducing your returns in the long term if you do not check on investment costs.
How To Reduce Investment Costs
Depending on the asset classes you invest in, you can always find ways to cut down on your investment costs.
For money market funds, you can go for the ones with low management fees. These include SANLAM MMF and Co-op Bank MMF, which have 1.2% and 0.9% management fees, respectively.
For Treasury bonds, instead of using third parties like brokers, commercial banks and investment banks, you can trade directly with the CBK to avoid the extra charges.
For stocks in the Nairobi Securities Exchange, you can go with brokers that charge lower commission fees and low or no account maintenance fees.
Also, avoiding managed funds as part of your long-term investments and instead going with ETFs will help you reduce investment costs in the long run.
The other thing is buying quickly and selling slowly. This means buying and holding your assets for the long term so that the accumulating profits are not affected by the increasing transaction fees.