Costs really do matter. Dr Benjamin Holdsworth gives the lowdown on the high charges that can impact your investment returns.
Hopefully, the idea that ‘costs matter’ when investing will not come as a surprise to you. It is remarkable, though, how relaxed some investors are about letting others dip their hands in their pockets to extract high fees.
The problem has two root causes. The first is that, in most walks of life, paying higher costs should help you to secure the best lawyer, architect or builder, yet when it comes to investing, this relationship is less black and white.
When investing, you may pay your financial adviser to undertake work on your behalf much as you would with the professionals noted above.
They will make recommendations, ensure tax efficiency of the products selected and provide guidance as to how your assets might be best structured to help meet your objectives.
And, of course, they will meet with you to monitor progress on an ongoing basis. But when they ultimately decide on a suitable portfolio for you and make investment selections, the cost for those funds and investments is an important factor to consider.
This does not mean that cheap investments are always the best, but higher fund charges do not automatically mean better results.
Impact of compounding
The second is that costs of, say, 2% a year do not sound very much, but unfortunately they are when compounded over time. In fact, the exponential impact of compounding can work both for and against us.
Imagine three different portfolios that deliver returns of 1%, 3% and 5% per year after inflation, but before other costs, over a period of 30 years: £100,000 invested in each would result in a growth of purchasing power to around £135,000, £240,000 and £430,000 respectively.
Seemingly small differences in the compound rates of return, turn into large differences in terms of financial outcomes. That is one of the great positives of a disciplined and patient approach to investing – small returns turn into big numbers, given time.
On the other side of the coin, costs – when compounded over time – eat away at these market returns to a far greater degree than many investors imagine.
For example, take two managers who deliver 3% gross – before fees – above inflation, where Manager A has costs of 0.25% and Manager B has costs of 1%.
Here costs matter a great deal; over a 30-year period, an investor in Manager B’s fund is over £40,000 worse off than an investor with Manager A’s fund.
Unfortunately, investors fail to consider the severe deductions from long-term wealth of the costs they suffer.
A pound of costs saved is no different to a pound of market performance in monetary terms, yet it is far more valuable due to its consistency over time and the fact that it is achieved without taking any more risk.
Minimising costs in an investment programme can have significant benefits, through the effects of compounding, over time.
Legendary investment guru Jack Bogle said: ‘In investing, you get what you don’t pay for.’ Multiple research sources identify the fact that low costs drive higher performance outcomes.
The use of low-cost products to implement an investment strategy provides a meaningful performance advantage over higher-cost alternatives.
It would be worthwhile paying higher fees to invest in a fund managed by a uniquely talented manager who can deliver returns above the market after all costs.
But only if we can be certain that their performance is due to skill and not luck – you need around 20 years of track record to split one from the other – and if we are confident that they will consistently deliver market-beating returns into the future.
Regrettably, those are big ‘ifs’ with little supporting data. In the absence of that level of certainty, focusing on managing investment costs as tightly as possible makes good sense.
Cavendish Medical believes that the priority is to have a well-diversified portfolio that matches the risk you are willing and able to take, and the purpose for which you are investing.
Good advice is worth paying for – but keeping investment costs to an appropriate level while doing so is a key part of our investment selection process.
Dr Benjamin Holdsworth (right) is a director of Cavendish Medical, specialist financial planners helping consultants in private practice and the NHS
The content of this article is for information only and must not be considered as financial advice. Cavendish Medical always recommends that you seek independent financial advice before making any financial decisions.
Levels, bases of and reliefs from taxation may be subject to change and their value depends on the individual circumstances of the investor. The value of investments and the income from them can fluctuate and investors may get back less than the amount invested.