You Paid What?!

Yesterday was a tough day for me. Aside from an atypical work schedule, my wife and I dropped off the kids and went to a car dealer searching for the perfect minivan. I hate buying cars and I agreed to this trip reluctantly. But we need the space with a third child on the way, and the thought of purchasing a $50,000 sport-utility vehicle makes me hyperventilate. So you can imagine how I felt when we first arrived and were greeted by a smiling salesperson. (Seriously, did someone paste "sucker" on my forehead?)

Fortunately, we entered the showroom prepared. I had secured a bid via fax ahead of time, knew the make and model we were looking for, and had already completed much of the negotiating in a phone conversation with the sales manager. I knew I was getting darn close to the best deal there was to get. There's a simple reason for this: Like fellow Fool Shannon Zimmerman, I'm a cheapskate.

Take that fence down a notch, fellas
Some folks are cheap simply because they like sticking it to the other guy. That's not me. It's just that I know what money costs having been more than $45,000 in debt. I know when I finance big purchases -- like a vehicle -- every tenth of a percentage in the interest rate counts. Huge. Interest owed is money lost; money that could be invested to earn market-beating returns for retirement. Take our house, for example. When we switched to a 15-year mortgage, our monthly payment rose by roughly $200 per month. But we also dropped the rate 2.5 points, knocking off more than $150,000 in interest owed over the life of the loan. That's a huge savings that will pay off big when our oldest, now 4, reaches college age.

Maybe there's a better way to think of this. Picture yourself running a long-distance race where every 20 yards or so you're faced with a hurdle. Figure that each of these hurdles is a cost that prevents you from saving more money for retirement. It could be debt, high taxes, exorbitant utility bills, or the fancy new entertainment system you paid for by raiding your IRA. Each cost makes each succeeding hurdle higher and harder to clear. Soon, you've simply given up; you figure saving any amount of money is impossible.

What you earn is determined by what you pay
Investing is the same way. Paying too much for the so-called privilege of investing your money is a sure path to market-lagging returns. But I don't need to tell you this, do I? After all, most people I know are bargain shoppers. They buy on sale. They negotiate the best deals for big purchases. They attempt even complex household maintenance on their own because they know hiring a pro is incredibly expensive. But so many of these same people also believe that paying more than 1% in annual investment fees is reasonable. Maybe they think they'll get what they pay for? Think again.

Consider the plight of two people I know, one of whom has been invested in mutual funds and stocks over the past nine years through an actively managed full-service brokerage account. He pays a fee of 2.4% annually. The other has had her funds in certificates of deposit over a lengthy period of time, earning sub-par returns as a result. Now she's considering an account managed by a local financial advisor who would charge 1.5% annually to manage her portfolio. Let's compare their potential performance versus a classic lightweight investment choice such as the Vanguard Total Stock Market Index (FUND: VTSMX  ) , which charges an annual expense ratio of 0.2%.

Let's figure the Vanguard fund will return an average of 8% a year over the next 10 years before the expense ratio. Now let's give each of the active managers a small premium over Vanguard, figuring that their talents will yield market-beating returns. I'd say it's fair to give the manager who charges 2.4% an average return of 10.5%, and the other, who charges 1.5% annually, a return of 9.5%. How will each do with $10,000 invested each year for 10 years? Have a look, and as you do, remember that I've figured contributions would be made on January 1 and that expenses would be applied on December 31 after returns:

Year Vanguard 1.5% Expenses/Year 2.4% Expenses/Year
1 $10,778.44 $10,788.18 $10,791.02
2 $22,395.92 $22,426.65 $22,435.62
3 $34,917.76 $34,982.44 $35,001.33
4 $48,414.35 $48,527.85 $48,561.00
5 $62,961.57 $63,140.88 $63,193.27
6 $78,641.21 $78,905.68 $78,982.97
7 $95,541.42 $95,913.02 $96,021.66
8 $113,757.21 $114,260.83 $114,408.13
9 $133,390.99 $134,054.77 $134,249.00
10 $154,553.15 $155,408.83 $155,659.31
Total Invested $100,000 $100,000 $100,000
Real Returns 54.6% total
4.4% annually
55.4% total
4.5% annually
55.7% total
4.5% annually


Look at both the real total and annual returns. If there's anything to learn from this chart, it's that annual investing fees can present a massive hurdle. And the reward for clearing it may be a relative pittance when compared to the no-brainer comfort of an index fund.

But there's more to this story, unfortunately. While there are a great many money managers who help their clients wallop the market's average returns, many more don't. So let's take a look at what would have happened were both managers in this case only able to match Vanguard:

Year Vanguard 1.5% Expenses/Year 2.4% Expenses/Year
1 $10,778.44 $10,640.39 $10,546.88
2 $22,395.92 $21,962.19 $21,670.54
3 $34,917.76 $34,009.03 $33,402.52
4 $48,414.35 $46,827.34 $45,776.09
5 $62,961.57 $60,466.53 $58,826.34
6 $78,641.21 $74,979.16 $72,590.28
7 $95,541.42 $90,421.17 $87,106.94
8 $113,757.21 $106,852.07 $102,417.47
9 $133,390.99 $124,335.20 $118,565.29
10 $154,553.15 $142,937.94 $135,596.20
Total Invested $100,000 $100,000 $100,000
Real Returns 54.6% total
4.4% annually
42.9% total
3.6% annually
35.6% total
3.1% annually


Your eyes hurt yet? How about your stomach? The fact is that many investors pay dearly for underperformance. Indeed, the person I know who pays 2.4% annually has suffered a net loss since contributing to his first funds more than nine years ago. You, and he, must demand better. Promise me that you will.

A Fool's errand: Get the facts
If you're really insistent on using a full-service vendor to manage your money -- be it a broker, advisor, trustee, or the family dog -- then you simply must get proof of her ability to create market-beating returns for other clients. Stocks provide no guarantees, of course. But over the long term, great managers who routinely beat the market soundly are absolutely worth the money. It's just that a mere fraction of them can beat the market's averages for 14 years running as has Bill Miller, legendary manager of mutual fund Legg Mason Value (FUND: LMVFX  ) . You should never pay 2.4%, or even 1.5%, for a manager with a record that isn't at least within spitting distance of Miller's. That goes for any fund manager, full-service advisor, or broker. Period.

Why not do it yourself?
By now, you've got to be wondering whether you might not be better off doing this investing thing on your own -- especially after seeing those Vanguard numbers. Good thinking, Fool. Many of the legends agree that there's no one better than you to manage your money. Peter Lynch is still my favorite among them. And his One Up On Wall Street is still the classic primer for the do-it-yourselfer.

There are plenty of ways to get started with cutting costs, and there are proven, profitable strategies to do a little better than the market in your investing. You'll find most all of them in our investing newsletters, any of which you can try risk-free. And while you'd be crazy to pass up the trial offers, you don't have to subscribe to anything to learn the art and science of Foolishly managing your finances in a market-beating, low-cost way. The best place to start is at our Fool's School. But you might want to fire that broker charging you 2.4% first.

Fool contributorTim Beyersis a confessed cheapskate. But he's nowhere near as creative as the geniuses at theLiving Below Your Meansdiscussion board. Tim didn't own shares in any of the companies mentioned in this story at the time of publication. To see what stocks are in his portfolio, check out his Fool profilehere. The Motley Fool isinvestors writing for investors.


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