Beginners guide to investing part 13:The impact of inflation and fees on returns

When reviewing our investment results, all may not be as it seems. Is that 7% return, actually 7%? Not if you have left out fees and inflation in your calculations. Two small, but not insignificant considerations that can eat away at your money.

 

THE EFFECT OF INFLATION ON OUR INVESTMENTS

There are several factors that create inflation. Mainly rising commodity prices and consumer goods and services. Increasing demand from consumers put pressure on supply levels, which generally leads to companies raising their prices. The cost of living increases with the rise in prices. Since 1994, the inflation rate in New Zealand has averaged 2.1% per year. This means that the cost of goods and services are doubling every 36 years. Assuming the same rate, $1000 today will only be worth $500 in 36 years.

Inflation is bad news for investors, as it erodes the purchasing power of our returns. Although stocks can carry high risk of losses, they also provide better protection than other asset classes against the effect of inflation. Especial moderate inflation. This is because companies can raise prices to cover higher costs to a degree. High inflation however, will not generally produce good results for stock investors. Generally, high inflation (5% or higher) leads to higher interest rates, which leads to more people moving out of the stock market into less risky investments such as bank deposits and bonds. This, in effect, lowers the value of stocks.

If our bank deposit returns are 3% and inflation is 4%, we are making a ‘real’ loss.  Don’t fall into the trap of thinking you have made a return of 3%. Because the cost of goods and services have increased by 4%, our investment returns have grown at a rate that is slower than increasing price of goods and services. In other words, we are earning less than we need to keep up with the increasing cost of living.  This is not a good place to be in when trying to grow our wealth or fund your retirement. Riskier, growth assets are the only way to combat inflation. This doesn’t necessarily mean ALL your income should be in growth assets.

Again, a well-diversified portfolio is the key to achieve sufficient returns, that beat the rate of inflation. Shares and rental properties tend to do well in times of moderate (1-3%) inflation. Bank deposits not so much. How much you put on each will depend on your tolerance for risk and how long you need your money to grow for.

We can’t stop inflation, but we can look for smarter ways to beat inflation so that we are not ‘losing’ money. It may feel like we are not losing money because our account is growing, but don’t be fooled. Slowly, over time, the effect of inflation creeps up on us and it is a very real cost.  Especially if our work income is only increasing at the same rate, or lower than inflation. Then, the effects are very noticeable. If our work income is increasing at a rate higher than inflation, we may not notice the effect as much. This is why inflation can be known as the silent killer.

The other way to beat inflation is to spend less. This is not to everyone’s liking, but it is an option nonetheless. It doesn’t matter then if the price of beer has tripled in our lifetime. Or the price of children toys. Of course there are things such as food and petrol that most of us have no choice but to purchase. Inflation beats us there. We can get one back on inflation by not spending so much on non-essentials is all I am saying.  This would help our investment returns go just that extra bit further.

 

THE EFFECT OF FEES ON OUR INVESTMENTS

Fees may seem small, but over time they can have a significant effect on your portfolio. I think the effect is best summarised in the table below:

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Assumption is for 7% returns, starting balance of $0, investing $4,000 a year for 30 years. You will note that an investment fund with 2% costs will leave us out of pocket by almost $90,000 less than a fund with 0.5% expenses.

Let’s change the assumption slightly to show how big the impact of fees can really be. Let’s now assume a starting balance of $10,000 and annual contributions of $12,000 per year.

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There is now a $290,000 difference between a 2% expense investment fund vs a 0.5% investment fund. This is huge. And for every 0.5% difference in expenses, there is a difference of $85,000 - $110,000. The difference in returns between 0.5% and 1% fees, being slightly greater than the difference between 1.5% and 2% fees.  

With the 2% fee scenario – of our $940,000 in returns, $420,000 have been paid to the fund manager in fees, and $520000 paid to us. Almost half the returns have been taken off us in fees. If we had slightly worse returns of 6% instead of 7%, then 60% of our returns would be paid towards fees, leaving us with just 40% of all returns.

We are committing all the money and taking on all the risk, yet the fund manager can potentially receive the same, or more, of the investment returns than we do. Fund managers get paid with our money regardless of how well the fund performs. We do not.

The difference in fees usually comes down to the level of service you receive. A high cost fund should have a full-time adviser managing your investments. A low-cost fund generally follows the results of the market and has no one making buy or sell decisions. The question then becomes, do you think you or a fund manager can outperform the market enough to make up the cost difference in fees?

Before you decide on your fund structure, be sure to understand and compare the fees you’ll be charged. Shop around. It could save you a lot of money in the long run.

There are generally two types of fees to look out for. Transaction fees for the cost of buying and selling stock. Ongoing fees for the maintenance of your investment fund. A few fund managers also charge extra if your fund performs well. This seems off to me, because fund managers should be investing for your fund to do well because it is in your best interests, not theirs. You, as the customer should be the incentive for the manager to perform well, not a bonus system. They do not refund your fees if the fund doesn’t perform well! I personally stay away from companies that I don’t trust and which I don’t think have my best interests in mind.

Not even all index funds are created equal. Some put a cap (such as 5%) on any one company. For example, if the biggest company in an index makes up 10% of the index, a fund with a cap may only allocate a maximum of 5% to this company. Whereas, another index fund that exactly mirrors the companies capitalisation in the market will put 10% of your funds towards that company. If the fund with the 5% individual company cap is slightly more expensive than the other index fund and you decide to buy index funds based on price alone, you may end up much less diversified than you hoped, especially if you are invested in a small market like New Zealand with a few large companies in the top ten comprising the majority of your index. 

 

FINAL THOUGHTS

Investment returns are often shown as a number BEFORE fees, tax and inflation costs. I didn't mention tax in this article as there is too much variation based on individual circumstances, but it is equally important to understand what taxes you pay and how you may be able to minimise them.  

So, when reviewing the performance of your investments and calculating how much you think you may have in future years, make sure to include the fees that you are paying, the cost of inflation, and tax into your calculations. If not careful, they can combine to take a large chunk of money that you work too hard for to give away.

2% fees do not sound like a lot, but when we are talking about an increasing amount of invested money compounding over long periods of time, it makes a massive difference to our returns. If we are investing with a high cost active fund manager, then make sure that returns are greater than the average returns plus fees. If you find a way to do this long term let me know!

But how can you guarantee higher than average returns? At least with fee reductions, you can guarantee the increased returns.

Do note that while low fees are important, they are not everything. It is also important to look at the company you are investing through and how reputable they are, what they invest in (each fund varies slightly in their allocations) and if it aligns with your investing goals, and any other important factors to you such as reporting transparency. 

In the final article of the investing series I will offer some final thoughts on how to stay on track with your plan and not get distracted.

 

 

The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here

 

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