Tag Archives: Investment

Unavoidable Trifecta of Investment Costs (UTIC)

unavoidable-trifecta-investment-costs

There are costs that can be eliminated, like the constant buying of disposable razors, and costs that can merely be reduced. When it comes to investing your savings, there are 3 costs that are unavoidable: taxes, inflation, and fees.

These 3 costs are especially repugnant because they add up to a lot. Bill Gates, still one the worlds richest people, claimed in 2013 that he had paid over $6 billion in taxes. You lose about 2 cents for every dollar you have in a regular bank account every year to inflation. And fees are baked in to nearly every financial service you can think of.

Though you can never be free of any of these costs, you can certainly reduce how much you end up paying. You could get a financial adviser or an accountant. Indeed, legally avoiding taxes is a giant industry. But the more help you get, the more fees you incur. Generally, fees are lower than taxes, but not always.

If advisers and accountants aren’t for you, or if you at least want to better understand all this stuff, there is, of course, this blog ūüôā

In a nut shell, to minimize tax payments, put your savings in a Tax Free Savings Account (TFSA), where it can grow tax free. If you’ve maximized your annual TFSA contribution, there’s always Registered Retirement Saving Plans (RRSP).

The best way to avoid fees is to learn about how your money works on your own. The more comfortable you are with saving and investing, the less need you will have for more expensive services, like advisers or accountants.

Unlike the other two prongs of this trifecta, inflation is truly unavoidable. The only thing you can do is make sure your money is growing faster than inflation, which isn’t always the case with high interest savings accounts.

 

Compound Interest – The Double Edged Sword

compound_interest

In my first post, I mentioned that I make decisions to buy certain things by weighing having something¬†vs the value of that item in 20 years, with interest, for when I retire. I mentioned buying an Xbox One, let’s say that costs $500. If I spend $500 now, I have an Xbox One, but what if I instead put that money into my S&P 500 TFSA?

Well, it just so happens that I have a Google spreadsheet that tells you exactly what happens right here. The document assumes we invested $500 into the S&P 500, in our tax protected Tax Free Savings Account (TFSA), so we don’t have to pay taxes at all on this. It assumes the particular S&P 500 fund we want to invest in keeps its current fund fee of 0.08%, and inflation runs at 1.5% annually. You’ll see that our $500 investment grows to about $3900.

For me, $3900 can easily be enough to let me live comfortably for a month or two when I decide to retire. So Xbox One now, or 1-2 months of extra retirement in 20 years? As a PC gamer, the choice was easy.

I remember first hearing about compound interest,¬†it sounded like¬†you could turn on the ‘compound interest’ switch and start making serious money. Albert Einstein described compound interest¬†as “The eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it”

Compound interest is the growth of your principle investment, and collecting interest on that growth in the next year (or compound period).

To illustrate with another example, let’s assume you have $1000 invested and your investment grows by 10% a year. Here is how that would work over 5 years:

  1. At the end of year one, your $1000 will grow by $100 (10% of $1000) to $1100.
  2. At the end of year two, your $1100 will grow by $110 (10% of $1100) to $1210
  3. At the end of year three, your $1210 will grow by $121 (10% of $1210) to $1331
  4. At the end of year four, your $1331 will grow by $133 (10% of $1331) to $1464
  5. At the end of year five, your $1464 will grow by $146 (10% of $1464) to $1610

Compound interest is the interest that grows off interest you’ve already¬†accumulated. Notice that after 5 years, your investment has grown to $1610, that is the base amount of your assets for year 6. Because of compound interest, it will take just over 7 years for your investment to double at a 10% annual rate of growth.

But compound interest can also work against you. Mortgages and credit card debt are good examples of that. If you have a credit card with an annual interest rate of 30% (the high end of interest rates in Canada currently), that 30% will be applied monthly or even daily by your credit card company. If it is monthly, you will be charged 2.5% (30% divided by 12 months) per month. As credit cards usually have a higher interest rate on overdue balances than most investments can return, this means that you can double your credit card debt in only a few years. This is one of the reasons why many financial advisers suggest paying off all your expensive debt before saving or investing your money.

If you are in the position of wanting to buy a house in Toronto or Vancouver,¬†and happen to have an amazing down payment where you’d ‚Äėonly‚Äô need a $500,000 mortgage, what would the (compound) interest be in 25 years? Using online¬†mortgage calculators, at a historically average 7% interest rate the banks will charge you, you’re looking at $550,623 in interest charges alone over 25 years. That is more than double the amount you borrowed.

Compound interest is the only way you can grow your savings and investments, it truly is the engine that drives the value of your savings up. But if you have a tough time controlling your spending, it also has the potential to cripple you in debt and force you to waste your time working only to pay off interest.

Fees – The Unavoidable Cost of Service

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Fees are one of the¬†Unavoidable Trifecta of Investment Costs (UTIC), taxes and inflation¬†being the other 2.¬†Fees are unavoidable because you really can’t even save your money, let alone grow it, without the services fees yield. Without banks, for example, you would have to store your paper money in a physical location in your house, which suddenly becomes vulnerable to fire, theft, and other bad things.

Types of fees to expect:

Bank fees / credit card fees РIt is really hard to function in our economy without a bank account. In addition to the physical protection and government insurance that blanket your money, banks provide loans to people who would otherwise not be able to launch their business idea, or buy their first house. Banks have many annoying fees (ATM fees, having a savings account with little money in it), but provide a lot of services that make buying things easier and safer. Certainly a necessary cost.

Stock trade fees РAs reviewed in my post about actually buying stocks, you will need a web broker that will execute your order. These typically cost from limited-time-free to $10 per trade. That means if you want to invest a bit of your money every month into the S&P 500, you might have to pay as much as $120 a year in web broker fees buying new shares.

Fund management fees – Every fund has a management fee that is charged to investors like us to pay for the management of the fund. This fee can include everything, include marketing and legal costs for the company that runs the fund. Generally, if the fund is human managed, you can expect fees of up to 1% – 2%.

1% – 2% may not sound like a lot, but it adds up to a lot over time. To illustrate, I’ve put together a spreadsheet in Google Docs that¬†has a table with a breakdown in money invested, investment growth, and fees. You can’t edit it from your web browser, but if you go to the top right and click File -> Download as, you can download the spreadsheet as your own .xlsx to play around with.

The spreadsheet can be found here, in it¬†you’ll clearly see how investing $200,000 over 20 years will result in a total take-home (before taxes) of $409,000 after $53,000 in a typical fund’s management fees are applied. If you play around with the spreadsheet, you’ll find that the more money you have invested, the more scary your fees will be.

Index funds, like Vanguards S&P 500, also have fees, but because index¬†funds are run by a fairly straight forward¬†computer program, humans generally aren’t involved. That makes index funds comparatively inexpensive, Vanguards S&P 500 has a Management Expense Ratio of 0.13%.

Financial adviser

Not everyone has a financial adviser, most don’t. But those who do will need to pay for them. Lots of large financial institutions will typically pay their financial advisers commission. Your financial adviser will probably take¬†a fraction of that 1-2% fund management fee, or they might take a cut¬†of any mortgage or other financial service they are¬†providing you.

I personally don’t like this payment model, it is one of the reasons why I decided to manage my finances myself. The problem is that obfuscating how your financial adviser¬†is paid will hide the fact that they are paid (and thus, motivated) more for selling you more profitable services, like insurance. And obviously, a financial adviser working and ABC Bank will only be able to help you with funds and services that ABC Bank provides, meaning you’re only getting the best products and services from ABC Bank, not the best products and services available.