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The Biggest Ripoff in Investing

By Dan Caplinger – Updated Oct 19, 2016 at 8:50AM

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Millions of investors pay a lot more than they should to invest because of one simple practice among financial professionals. Find out what it is and how you can avoid it.

This article was updated on Dec. 28, 2015.

Millions of investors get ripped off every day. The odds are good that you're one of them. And the saddest thing is that the vast majority of those who fall prey to this common practice will never know that it costs them hundreds of thousands of dollars over the course of their lifetimes.

This ripoff is so blatant that it's completely out in the open. No professionals hide it. Yet most people never think twice about it, because it's the common practice among Wall Street investment managers like Goldman Sachs (GS 1.86%), Morgan Stanley (MS 1.96%), and Bank of America (BAC 1.06%), as well as mutual funds and other investment vehicles. The ripoff? Charging a fee that's based on a percentage of the assets you own.

What a difference it makes
Ironically, professionals who don't charge based on a percentage basis tend to get the most criticism for their fees. Lawyers charge hourly rates that are directly tied to the amount of work they do, regardless of the amount of money involved (except for those who work on a contingency-fee basis). Similarly, plumbers, electricians, and other household-repair professionals charge hourly rates -- and they tend to be the same rates for a mansion and for a tiny apartment. And while higher-end issues might take more time to solve -- and therefore require a higher fee -- it intuitively makes sense to get paid more when you have to do more work to get the job done.

Yet when investment professionals charge 1% to 2% in annual fees, the amounts involved can be much larger. At first, it might seem like a steal to enjoy the services of a broker or financial advisor for just $20 to $40 in annual fees on a $2,000 investment, even if all it means is a quick hour-long meeting once or twice a year. But as your portfolio grows, that 1% to 2% grows with it. If you're a millionaire, you have to ask yourself: What did your broker do to earn the $10,000 to $20,000 in annual fees you paid?

Over time, those fees add up. According to one study, a typical household should expect to pay more than $150,000 in 401(k)-related fees, eating up about a third of their investment returns from their workplace retirement plan. Add in the costs from assets outside your 401(k), such as regular taxable accounts, IRAs, and other investments, and you'll see even more of your hard-earned money siphoned out of your retirement nest egg to support Wall Street lifestyles.

Get what you pay for
Admittedly, some financial advisors do more work for their high-end clients than they do for a typical $5,000 accountholder. The best planners will coordinate work with legal, accounting, and other professionals to put together a comprehensive financial plan that will incorporate estate planning, retirement planning, and other needs. As a client's assets grow, so too do those needs, and so a competent professional should spend more time on that work. Yet unfortunately, under the percentage-of-assets model, there's not as much incentive for professionals to actually do that extra work.

When it comes to smart investing, the essentials of finding great investments are the same whether you have $10,000 or $10 million. Looking for great stocks with solid fundamentals, including prospects for growth and reasonable valuations, is the same no matter how much money you have. If the effort is the same, shouldn't you pay the same -- regardless of how wealthy you are?

Clearly, Goldman, Morgan Stanley, and Bank of America -- all of which offer managed accounts with hefty percentage fees -- think that you should pay more for their guidance as you get richer. But you can and should expect innovators to challenge that belief. The efforts of those willing to challenge the Wall Street paradigm could put hundreds of thousands of dollars back in your pocket and change the way investment professionals do business. All you have to do is refuse to accept the status quo and demand a better alternative.

Since no one likes to pay exorbitant fees to invest their money, check out this comparison of online brokers that charge a lot less.

Dan Caplinger owns warrants on Bank of America. The Motley Fool recommends Bank of America and Goldman Sachs. The Motley Fool owns shares of Bank of America. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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