Wealth in our Woods Column: When small fees become big money

By Kyle Green, CFP®, Sherwood Wealth Management

SHERWOOD, Ore. — When it comes to investing, fractions of a percentage point don't sound like much, but over time they can make a substantial difference.

Suppose you are comparing two investment advisers. One charges an annual management fee of 1.40%, while the other charges 0.85%. The difference is just 0.55 percentage points. On a $50,000 investment account, that's only $275 during the first year.

In the context of a long-term investment strategy, $275 may not seem particularly significant. But there is another cost that is much easier to overlook.

You don't just lose the money you pay in fees. You also lose everything that money could have earned in the future. That's because compounding works both ways.

We usually talk about compounding as one of an investor's greatest advantages. When your investments earn a return, those earnings remain invested and have the opportunity to generate earnings of their own. Given enough time, that cycle can produce remarkable results. Investment fees interrupt that cycle.

Consider an investor with a $500,000 portfolio earning an average annual return of 7% before management fees. For simplicity, we'll ignore taxes, fund expenses, and other potential costs and look only at the management fee.

With a 1.40% annual management fee, the investor effectively earns 5.60% before considering those other costs. With a 0.85% fee, the investor keeps 6.15%. Again, a difference of 0.55 percentage points doesn't sound dramatic. After one year, it isn't. But give compounding 20 years to work, and the difference becomes much more interesting.

Assuming those returns remained constant, $500,000 growing at 5.60% annually would become approximately $1.49 million after 20 years. At 6.15%, it would grow to approximately $1.65 million. That's a difference of roughly $160,000.

The investor paying the higher fee didn't write checks totaling $160,000 more to an adviser. Much of the difference comes from the growth that never occurred because more money was removed from the account along the way. Stretch the example to 30 years and the difference becomes even larger: roughly $450,000.

This is why seemingly small differences in investment costs deserve attention.

That doesn't mean the cheapest investment adviser is necessarily the best one. Cost and value aren't the same thing. An adviser who provides comprehensive financial planning, tax planning, retirement projections, behavioral coaching, or other valuable services may reasonably cost more than one who simply manages investments. Likewise, an inexpensive service isn't a bargain if it doesn't provide what you need. The important thing is understanding what you're paying and what you're receiving in return.

If you work with an investment adviser, find out what percentage you're paying for management, then look beyond that number. Are there expenses inside the mutual funds or exchange-traded funds you own? Are there commissions, transaction costs or other fees? What services are included in the advisory fee? Most importantly, ask whether you're receiving enough value to justify the total cost.

Investors spend a great deal of time wondering what the market will return next year. Unfortunately, none of us knows the answer. Fees are different. They are one of the few variables investors can know in advance and, to some extent, control. Half of a percentage point may not seem important today, but when you're investing for decades, sometimes the smallest numbers deserve the closest attention.