The Tyranny of Compounding Costs: How Fees Silently Eat Your Wealth

When it comes to most purchases, you get what you pay for. When it comes to investing, you get what you don’t pay for.

You might notice that when you open up an account and hand over some money to be invested, it seems like it’s free. They don’t mention a price, they don’t send you a bill, they don’t ask for a credit card.

Of course, it’s not free, the fees are just well-hidden.

Every day stocks and other securities go up and down in price, causing the value of your portfolio to change daily. Amid the sea of ups and downs, it’s virtually impossible to notice when your broker quietly extracts your annual fee from your account.

How costly are these fees? Let’s break it down.

The Expense Ratio

This is the big one. Almost every fund has an expense ratio. It’s the main way that investment firms make their money.

The expense ratio is expressed as a percentage of your assets that will be paid as an annual fee to the broker. So if you have a million-dollar portfolio and an expense ratio of 1%, your broker will charge you $10,000 to invest your money.

While the dollar amount varies, this fee gets charged every year. It doesn’t matter if your investments made money or lost money.

If you want to maximize your returns, you’ll need to minimize your costs. You’ll want to select a fund with an expense ratio that’s as low as possible.

Index Funds vs Mutual Funds

An index fund is a kind of mutual fund. Instead of a traditional actively-managed fund where a fund manger picks stocks, an index fund tracks an index like the S&P 500 or a total stock market index.

So while you might have a fund manager and a team of analysts picking stocks for a traditional mutual fund, an index fund basically runs on an algorithm.

This is important because teams of analysts aren’t cheap. The price of these “experts” gets passed to you in the form of a higher expense ratio.

One of the primary benefits of index funds is that they cost less than most mutual funds.

How Investments Grow Without Fees

Let’s pretend you invested $10,000 for 40 years at 5% interest. We’ll also assume you paid no fees. Here’s what the growth would look like over time:

Of course, in the stock market there’s no way this line would be so smooth. This graph and the ones that follow are just to illustrate the principles.

In our fictitious example, you did pretty well for yourself. You let the power of compound interest turn a $10,000 investment into a $70,400 portfolio.

Investment	Ending Balance	Total Fees	Portfolio Drag
$10,000	$70,400	$0	$0

The Impact of Minimal Fees

Let’s go back to that same example, except now you are paying the tiny expense ratio of 0.04%. That’s not a random number I picked. that’s the expense ratio of VTSAX, Vanguard’s Total Stock Market Index Fund.

Here’s what your graph looks like now:

Let’s be honest, this doesn’t look to bad. In fact, it’s really not bad at all.

Investment	Ending Balance	Total Fees	Portfolio Drag
$10,000	$69,282	$502	$1,118

Instead of $70,400, your $10,000 investment turned into $69,282. Not too shabby.

Over the course of 40 years, you paid a little over $500 to your fund’s expense ratio. Of course, you also missed out on all the compounding that the $502 would have earned you. So the expense ratio actually represented a $1,118 drag on your portfolio.

In this case, the damage isn’t too bad. But the difference between what you paid in fees and how much you lost due to fees illustrates an important point: these costs are compounding against you.

The higher your fees and the longer you invest, the more of your portfolio value disappears due to fees.

The Impact of Normal Fees

Chances are most mutual funds you run across will have an expense ratio of somewhere between 0.5% and 1%. Let’s look at both ends of that range.

The Low End of Normal

Now we’re starting to see the problem. Let’s dive into the numbers:

Investment	Ending Balance	Total Fees	Portfolio Drag
$10,000	$57,610	$5,585	$12,790

You’ve paid over $5,500 in fees and have nearly $13k less than you would have with no fees.

Notice on the graph how the gap between the green line and the red line is growing over time. This is the tyranny of compounding costs.

The High End of Normal

Definitely looking scarier. How did the numbers shake out?

Investment	Ending Balance	Total Fees	Portfolio Drag
$10,000	$47,096	$9,861	$23,304

You paid nearly $10k in fees and we’ve hot the point where your total losses are in the multiple tens of thousands of dollars.

Remember, this is on a one-time $10,000 investment. The good news is that your investment multiplied by 4.7x. The bad news is that it should have multiplied by 7x.

The Impact of High Fees

Buckle up, because things are about to get crazy. I hope you never invest in a fund with a 2% expense ratio, but here’s what it looks like in case you’re curious:

If that didn’t scare you here are the numbers:

Investment	Ending Balance	Total Fees	Portfolio Drag
$10,000	$31,377	$15,480	$39,023

This is probably the first one where there’s a chance you don’t believe me. Run the numbers yourself. There is a chance you’ll get something slightly different. For instance, removing the fee before calculating the returns vs. after will make a difference. But your numbers will be pretty close.

One way you can check your work is to do the 40 year growth of $10,000 at 3% (since a 3% return is equal to a 5% return minus a 2% fee). This was how I checked my math. These numbers paint an accurate picture.

It’s hard to wrap your head around how more than half your potential money vanished. Especially since the fee was less than half of your rate of return. But again: the distance between the green line and the red line is compounding. In this example it’s compounding at the highest rate we’ve yet observed.

Real World Numbers

Instead of our perfectly smooth curves that take advantage of fake numbers, let’s look at what happens in the real world. I went on Vanguard’s website and got the returns of their total stock market index fund from 2006 through 2020.

Let’s imagine that you are saving $10,000 per year (as opposed to $10,000 one-time like before). This helps the realism since most people make regular investments over a period of time.

How Your Money Would Have Grown With No Fees

It’s still not fully realistic because it’s smoothed out over the course of a year and doesn’t show the market’s daily fluctuations.

But you get to see how the annual $10,000 investments grow linearly while the earnings compound. In this example, you briefly have your balance dip below your invested capital during the 2008 market crash.

It doesn’t look like that big of a deal because:

• It happened early when you had little capital invested
• Your contributions help smooth the ride

Here are the stats we’ve been looking at for each example:

Total Investment	Ending Balance	Total Fees	Portfolio Drag
$150,000	$439,524	$0	$0

The Actual Net Return of VTSAX

The returns from that last example come from Vanguard’s Total Stock Market, VTSAX. But those are just the gross returns. To find the net returns we have to adjust for the expense ratio, which is 0.04%.

Total Investment	Ending Balance	Total Fees	Portfolio Drag
$150,000	$437,845	$923	$1,680

The blue triangle is you taking care of your future self. The green area is the market taking care of you. The thin little red line is your investment firm taking care of you.

The Impact of Higher Fees

Total Investment	Ending Balance	Total Fees	Portfolio Drag
$150,000	$419,013	$11,220	$20,511

Total Investment	Ending Balance	Total Fees	Portfolio Drag
$150,000	$399,520	$21,779	$40,005

Total Investment	Ending Balance	Total Fees	Portfolio Drag
$150,000	$363,385	$41,055	$76,139

In each of these examples—even the modest 0.5% expense ratio—you are losing out on tens of thousands of dollars over just fifteen years.

The True Cost of Fees

So far the examples we’ve gone through have illustrated the point, but have actually understated the severity.

Our first set of examples was of $10,000 invested one-time. Our second set looked at recurring investments, but covered a time period of just fifteen years.

Let’s look at what happens over the wealth accumulation stage of an investor who invests $10k a year from when he starts working to when he retires 40 years later.

Total Investment	Ending Balance	Total Fees	Portfolio Drag
$400,000	$1,254,971	$7,243	$13,427

Ah, our familiar thin red line. You might have noticed that for the first time our minuscule expense ratio has cost us more than $10, but it’s not a huge deal at this scale. Your investment should be worth $1.2 Million and is actually worth…$1.2 Million.

Total Investment	Ending Balance	Total Fees	Portfolio Drag
$400,000	$1,111,512	$83,474	$156,885

Ouch! Fees have robbed more than $150k from your net worth. At least you’re still a millionaire.

Total Investment	Ending Balance	Total Fees	Portfolio Drag
$400,000	$976,223	$153,173	$292,175

This is not cool. You’ve paid out $150k, lost nearly $300k, and you’re not even a millionaire anymore.

Total Investment	Ending Balance	Total Fees	Portfolio Drag
$400,000	$758,524	$259,621	$509,874

This chart makes me sick. A half-million dollars down the drain.

You’ll notice that with every expense ratio except the tiny 0.04%, you lost more than a hundred thousand dollars. It’s not an exaggeration to say that for the average investor, hundreds of thousands of dollars are at stake when it comes to controlling investing costs.

This has enormous ramifications for your ability to become Financially Independent

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Related Post: The 4% Rule: How Much Money Do You Need to Never Work Again?

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Protecting Your Money

Hopefully this post has drilled one key idea into your mind: To protect your wealth, you need to minimize investment fees.

It doesn’t look like they cost you anything because you don’t whip out a credit card and “pay” for them in the traditional sense. But they are real, and they’re a real threat to your assets.

Your returns aren’t guaranteed, but the fees are. Your investments could lose money and you’ll still need to pay fess. If your investments go up, you’ll pay higher fees.

Any investor who cares about their capital makes it their business to declare war on fees.

Other Kinds of Fees

We’ve been talking exclusively about the expense ratio because it’s the most pervasive fee. But it’s just the baseline. Here are a few examples of other fees that funds may charge:

• Load fees
• Account fees
• Exchange fees
• Redemption fees
• Purchase fees
• Deferred sales charges

It’s not important to cover what those mean, you want to avoid all of them. The only way to know for sure what fees your fund charges is to read the fund’s prospectus.

Fortunately, as we covered earlier, one kind of fund consistently shines when it comes to fees.

Index Funds

Index funds are pretty reliably low-cost investment vehicles.

I can’t guarantee that every single index fund out there is low-cost, but as a general principle they are much cheaper than their actively managed mutual fund counterparts.

For instance, we’ve been talking in this post about VTSAX: Vanguard’s Total Stock Market Index Fund. It carries a microscopic 0.04% expense ratio and the only other fee is in annual $20 account service charge for certain balances under $10,000.

In the low-cost fund war, there’s actually one fund that is even more impressive: FZROX Fidelity ZERO Total Market Index Fund. The ZERO in the name refers to an unprecedented 0.0% expense ratio, and according to the prospectus, there are no other fees.

Of course, the absence of fees is likely a marketing strategy to get your foot in the door. It’s not clear which fund is better, especially when you consider Vanguard’s competitive advantage in keeping costs low over the long term.

If you want to read a more comprehensive comparison, check out this post:

Related Post: FZROX vs VTSAX: Which is the Best Low-Cost Index Fund?

Final Thoughts

COSTS MATTER.

Was that enough emphasis for you? Declare war on fees and keep as much of your money as you can.