We all know the drill. Start early, be consistent, give it time, and then allow the jet fuel known as compound interest to blow your socks off.
The legend is indeed true – compound interest is a really powerful force that can do wonders for a financial freedom dream (or any other long-term financial goal).
But what if I told you there was a way to make compound interest even more powerful – compounding your compounding as it were?
Okay, time to meet the Smiths, a couple who have managed to carve out R5 500 a month from their budget. They have decided they aren’t getting any younger and want to put this money towards their retirement.
Let’s walk with them down the road many people would take when faced with this situation. First up, they find a financial advisor. Maybe it’s the one their parents used or their friend’s connection, or perhaps they do a Google search. Either way, they find someone and arrange a meeting so they can get their investment up and running.
Now let’s say this advisor is actually semi-decent, independent and not just after fees. The advisor realises that because both the Smiths have a pension fund at their work, it is probably better to diversify their tax treatment a little bit, while at the same time getting them some additional offshore exposure by putting them in tax-free savings accounts (TFSAs) and not a retirement annuity (RA) – see I told you the advisor wasn’t just fee-hungry.
And would you look at that – it just so happens that the R5 500 the Smiths have available to invest is the exact amount they need to max out two TFSAs. Wow, what a coincidence.
Okay, let’s assume the advisor puts them in a cheap, passive, equity-focused, offshore investment (maybe something like the Satrix World; I say again, this advisor is a good one) that gets them a 12% annual return. Let’s say the advisor takes what seems to be the industry standard fee of 1% per annum (with Vat included that equates to 1.15% per year).
There’s nothing unusual about any of this and off the Smiths go on their investment journey.
Fifteen years pass, and in that time, the usual market crashes and recoveries happen, maybe the Springboks win a world cup, and I even get around to finally fixing the light my wife keeps nagging me about.
The Smiths’ TFSA investments end up at a combined value of R2.347 million. Not too shabby.
Okay, now let’s consider another path the Smiths could have taken. You see I forgot to mention that Mr and Mrs Smith have been a little stressed out lately and they could really use a holiday – and we’re talking international.
So instead of starting their investment, they decide to stash their money away for six months. They then take the R33 000 they have saved up and go on an epic overseas trip.
But something else happens during the six months when they’re saving for the holiday …
Mrs Smith starts listening to the Just One Lap Fat Wallet podcast every Monday on her way to work. And Mr Smith spends about 30 minutes a week reading up about investing on news sites, googling the stuff he doesn’t understand, and even starts following some personal finance blogs (okay, maybe I am a little biased, so I had to throw that last one in there).
Little by little, the Smiths start gaining some knowledge. It doesn’t feel like it, but small incremental gains each week result in them accumulating a decent amount of investment smarts.
They learn things like:
- For a long-term investment, you need to have some growth assets like equity.
- Diversification is important, as it can reduce your risk and enhance your returns.
- Passive exchange-traded funds (ETFs) are low cost, and because they track the market, they don’t run the risk of underperforming the market.
- A TFSA can be a great alternative to an RA.
- When investing for the long term, you need to ignore the media noise and prophets of doom. Markets go up and markets go down – selling when markets are down is a terrible idea.
- Patience is important, and it’s the time in the market that counts.
After their holiday (a full six months after the scenario where they started investing through a financial advisor) they finally open their TFSA accounts themselves and start DIY-ing their R5 500 a month investment.
Now, bearing in mind that starting early is one of the most important factors when it comes to investing, and in the second scenario the Smiths have lost out on the first six months of contributions and growth, do you think their investment would be worth more or less than the first scenario, where they started immediately but used a financial advisor?
Well, the results are in …
Yes, that’s right – despite starting later (and losing the most important first six months), contributing less, and having the investment run for a shorter period of time, the Smiths ended up R100 000 better off than if they had started immediately through an advisor (R100 000 – that’s enough for some more international holidays in retirement).
The main reason for this is due to the R154 000 in fees the Smiths would have paid for using the financial advisor.
You see, compound interest gets some rocket fuel when there is no drag of an advisor charging a percentage-based fee.
And remember, when it comes to fees, it’s not just the money that gets paid over, it is also the lost compounded growth that money would have had if it had stayed invested instead.
Compound fees are the nemesis of compound interest
Yes, I get it – investing can get scary, especially when the markets pull a wobbly or the returns go nowhere for five years (I won’t mention any names *cough* JSE All Share Index *cough*). In times like these, you can call up your advisor and they will tell you: “Don’t worry, everything is going to be okay. Just keep at it; this is pretty normal and par for the equity investing course.”
For many people, this can be really reassuring. But you’ve got to ask, is it worth paying R100 000 for? Heck, drop me a mail and I will tell you all those things for free.
But maybe I’m being too harsh. Maybe there is a middle ground to the fee-versus-guidance issue?
Well, I think there might just be.
Allow me to present one more scenario to you.
Hacking the financial advisor system
To understand how you can get the best of both worlds – some guidance to get your investment up and running, while not paying too much in fees – let’s first look at the rand value the Smiths would have paid in fees for each year they used a financial advisor:
Interesting. That looks a lot like a compounding chart, doesn’t it?
That’s because it is!
And this is the problem with percentage-based fees: as your investment grows exponentially, so do the fees.
In year one, the Smiths would have paid a palatable R428 in fees. But in the last year, they would fork out over R25 000. Eina!
In fact, the fees paid in the last year alone would be more than the combined fees of the first seven years.
And remember, I’m only showing a 15-year timeframe. If this investment runs longer (as many retirement investments will) the fees will continue their exponential march ’til they get to the moon, circle round and then bite the Smiths in the behind.
So here is what I think is a good compromise for someone who wants to start investing and would like the guidance a financial advisor can provide, but is maybe put off by paying too much due to percentage-based fees.
Let’s see what happens if the Smiths set up their investment through a financial advisor, and then during the first three years, while the advisor’s fee is reasonable, they gain some investing knowledge, start understanding how it all works, and then take over the investment themselves at the start of the fourth year.
This is what their investment would look like (versus the scenario where they went on holiday and delayed their investing by six months):
In this scenario, they end up with over R2.6 million. That’s more than R150 000 better off than if they went on holiday and delayed their investment by six months, and a full R250 000 higher than if they had kept the advisor for the full 15 years.
Now I don’t know about you, but taking some time to learn a little bit about investing seems like a small price to pay in exchange for R250 000. And doing it at a leisurely pace over three years doesn’t seem like that big of an ask at all.
Okay, let’s wrap this all up really quickly by summarising the investment outcome, contributions made, and fees paid for each of the three scenarios:
Investing through a financial advisor results in an ever-growing and compounding fee bill, as well as some serious lost growth on the money that was paid away in those fees.
The Smiths’ investment outcome was significantly improved by taking some time to learn DIY investing. This skill is so valuable that they were able to achieve a better outcome even after missing the most beneficial first six months, going on a holiday instead, and contributing less in total.
But the best scenario is the case where the Smiths start their investment immediately through a financial advisor, but then go it alone after three years. Yes, there are some fees to pay, but that number doesn’t even register on the chart above.
And it is this scenario that I think pretty much sums up everything I want to say:
- Starting early (as in right now) is super-important.
- It’s so important that even if it means starting your investment by using an advisor, that is fine. But …
- Once your investment is up and running, costs become really important. Spend some time to educate yourself, because percentage-based fees quickly become a total rip-off, and learning to invest on your own could be one of the highest-paying skills you will ever learn.
Yes, it’s true – you are not going to learn everything there is to know about investing overnight. But putting in a little bit of effort on a regular basis, over an extended period, will prove to be well worth the six- or even seven figures you can save in fees.
This article was originally published on the Stealthy Wealth blog here.
The views and opinions shared in this article belong to their author, cannot be construed as financial advice, and do not necessarily mirror the views and opinions of Moneyweb.