Financial markets is this vast space with so much going on. You hear of things called stocks, bonds, derivatives, funds, funds of funds, and of late, crypto currencies. And on top of that, you get stockbrokers, investment managers, fund managers and day trading firms that promise huge returns on your investments. So where does investing for your retirement fit into all of this? And how do you do it?
Retirement accounts
Retirement accounts normally have a set of rules that have been created to protect investors from too much volatility that could have very adverse impacts on their investments. These accounts normally have to have a good mix between normal local and offshore stocks (these would be shares in companies like Walmart or BP), a good amount of bonds (these are long term debt held by big corporations & governments and listed on exchanges so that you and I can buy into them and share in the earnings of those interest payments), and property. Just like shares in companies, we can buy shares in property portfolios that are run by large property fund managers. This is great because it allows us to hold shares in a wide range of premium properties with relative ease and low cost.
The Investment Manager or Broker
Now, normally, if you would invest for your retirement, the company you work for would have appointed a broker and they do all of that. Alternatively, you could appoint your own investment manager to make the decisions and handle the investments on your behalf, but in return for their services, they take fees, primarily in two ways, a yearly ‘management fee’, and an ‘initial investment fee’. The yearly management fee can be anything from 1% – 2%, while the initial investment fee can be of the same magnitude.
Now, in order for these investment managers to actually be of any value to you and me, they need to keep track of which funds are the top-performing funds and which are the losers, and try to always stay with the good performing funds. This means that every 2-3 years, your portfolio will need to be rebalanced and investments made into new funds, triggering the initial investment fee described above all over again, this time called a ‘rebalancing fee’.
The Fund Manager
On top of this, the funds they invest in are run by fund managers, these are people working for big companies such as banks and investment houses and supposedly have a glass ball to see into the future and will somehow know which stocks are best to invest in for their funds and which are not. Now, while they do have a lot of research to go on and a very good understanding of the market, they simply don’t know what will happen tomorrow, as proven by the many historic market crashes we’ve seen. I guess what I’m saying, is that while these fund managers might be pretty smart, they can’t see into the future any more than you or I can.
On top of that, they also take a fund management fee, which normally consists of a baseline fee of between 1% – 2%, and an outperformance fee, which is usually quite high and which they can charge, should their fund outperform the benchmark against which they measure their fund.
So what is the alternative?
It’s actually not that tricky. With technology these days, any normal person on the street can go online and open an investment account with their local investment house or their bank, and for the most part, they all list each other’s funds and they’re all fairly competitive on their fees, so as long as it’s a solid company, you should be in fairly good hands. So what you would do is open an account with your chosen investment house and manage the investments yourself!
Wait, this sounds dumb?!
You might think that at this point, but this is where it gets interesting. Remember the fund managers we talked about above, those smart guys that have their own funds and decide what stocks to put in them? Well, historically, they’re pretty much not-great.
We also spoke about the Benchmark above, something they measure their fund performance against. Say the fund manager’s fund invests primarily in stocks listed on the Dow 30 exchange, the Dow 30 representing the 30 biggest industrial stocks in the world, including names such as Apple, Nike & McDonald’s. What his job is primarily about, is to decide which stocks he thinks will be the best-performing stocks in the next 1-3 years, and invest the bulk of his funds’ money into those stocks. That means he doesn’t have to have all 30 of those stocks in his portfolio, he could just hold 10 or 15 of them, and have different amounts invested into each of those, based on what his research tells him would be a good investment. Some years he’s right, other years he is wrong.
Back to the Benchmark. Exchanges like the Dow 30 also have passive funds tracking them. These are funds not managed by a fund manager, but simply consists of each of the exchanges’ stocks, in their each respective weightings. That means that if Apple makes up 10% of the Dow 30’s total value, the fund will have 10% of its money invested in Apple. And as Apple’s value changes daily along with all of the other stocks listed on the Dow 30 exchange, the fund constantly readjusts itself to stay in line with the weighting of the exchange. It doesn’t do any research, and it doesn’t have an opinion. It simply holds the shares in their respective market weightings.
Why should you care?
There are thousands and thousands of investment funds run by ‘smart’ fund managers around the world and you know what? Historically speaking, very few, if any, have ever outperformed their benchmark over the long term. Since we’re talking about your retirement here, a 30 – 40 year investment cycle, this is quite relevant.
You see, these passive funds described above, normally called index trackers, while unopinionated, gives you the true return of the benchmark they are tracking. Not only that, but since they are passive funds and don’t need to pay the large salaries associated with smart fund managers, nor have any outperformance fees attached to them, their fees are generally quite low, about 0.2% – 0.5%.
In addition to this, since they simply track the exchange’s performance, you don’t need an investment advisor to decide which funds are the best for your portfolio, you can simply go out and buy into the index tracking funds that track the biggest exchanges in your local market and that would be a fairly safe bet.
But why do all that effort when I can simply hire an investment manager?
The real difference lies in the fees, and the compounding nature of it. Say you’re handling the investments yourself, investing into passive index tracking funds and your fund returns an average of 10% per year over 5 years, while your total annual fees are at 0.5%. On a $100,000 figure, your investment would now look like this:
- Year 1 – 10% return: $109,500 ($10,000 return – $500 in fees on your $100,000 investment )
- Year 2 – 10% return: $119,902.50 ($10,950 return – $547.50 in fees on your $109,500 investment )
- Year 3 – 10% return: $131,293.24 ($11,990.25 return – $599.51 in fees on your $119,902.50 investment )
- Year 4 – 10% return: $143,700 ($13,129.22 return – $722.11 in fees on your $131,293.34 investment )
- Year 5 – 10% return: $157,280.15 ($14,363.48 return – $790.35 in fees on your $143,700 investment )
That puts your compounded return over 5 years at $57,280 or 57.3% after fees.
Comparatively, if you had used the services of a investment manager with the same average annual return over 5 years of 10%, although with slight annual variations, and annual management fees of 2% for the investment manager and 2% for the fund manager, as well as initial investment fees of 2% in year 1 and 2% rebalancing fees in year 3, and on top of that, outperformance fees charged by the fund manager in years 3 & 5 of say, 5% on the outperformance amount, your investment would look something like this:
- Year 1 – 8% return: $102,000 ($8,000 return – $6,000 in fees on your $100,000 investment)
- Year 2 – 10% return: $107,712 ($10,200 return – $4,488 in fees on your $102,000 investment)
- Year 3 – 12% return: $113,420.74 ($12,925,44 return – $7,216.70 in fees on your $107,712 investment)
- Year 4 – 7% return: $116,823.36 ($7,939.45 return – $4,536.83 in fees on your $113,420.74 investment)
- Year 5 – 13% return: $127,162.17 ($15,187.04 return – $4,848.17 in fees on your $116,823.36 investment)
That puts your compounded return over 5 years through an investment manager at $27,162 or 27.2% after fees. That’s a massive $30,118 difference in just 5 years, your investment returned less than half if would have if you had just been invested in passive index trackers. Imagine what that figure will grow too in 40 years, all because of the negative impact the fees have and the compounding nature of it.
The gist
Fees are the killer. And yes, with a little bit of research into good investment houses and popular index tracking funds and their associated returns and annual fees, you can easily manage your own investments. From my own experiences, I can vouch for this approach.
Just a final note – at the top of this article I mentioned bonds and property investments through funds which forms part of a holistic retirement investment approach, which we did not really touch on in this article as it has gotten a bit lengthy. I have written separate articles on those, you can read more on those topics here: Investing in Bonds & Investing in Property through Funds
Disclaimer
This article was written to give insight into managing your own investments, and the detriment effect high fees can have on your long-term investment growth. The examples used have been written in a way to simplify the understanding, although the fundamentals remain the same. By no way does the above constitute investment advice, and consulting with your local investment advisor is recommended, at the very least for a second opinion.