Many investors seek professional advice to help them pick suitable investments. But few of them completely understand just how costly that advice can be. Let's look at how, with just one common mistake, you could end up costing yourself thousands or even tens of thousands of dollars, even if you make relatively modest investments.
One of the ways many brokers get paid is by selling mutual funds that carry front-end sales loads. In funds with sales loads, a percentage of your investment goes not to the mutual fund to invest on your behalf but rather to your broker or the company your broker works for.
Regulators provide only limited protection to investors with regard to sales loads. The Securities and Exchange Commission doesn't limit sales loads at all, instead leaving that job to the independent non-profit Financial Industry Regulatory Authority. FINRA imposes an 8.5% maximum on sales loads, with lower limits applying if funds charge other types of fees as well.
The impact of sales loads
At first glance, a sales load may not seem like all that big a deal. Paying your broker $85 on a $1,000 investment may seem like a reasonable amount of compensation, especially if your broker helped you put together a broader strategic plan for your investments both now and in the future.
But the long-term impact of sales loads is much greater. Because your sales load gets taken off the top of your initial investment, it never has a chance to earn a return on your behalf. So not only do you end up losing $85; you also lose the potential gains and income that your lost $85 would have produced.
Moreover, if you're like most investors, you'll continue making additional investments over time. A sales load can apply not just to your initial investment but to subsequent purchases as well, so you'll pay that $85 over and over again.
OK, but where do you get $76,901?!
When you combine the impact of repeated sales loads and lost earnings, the final cost of investing in a fund with a sales load can be truly shocking. If you invest $1,000 annually for 40 years in a fund that charges an 8.5% sales load and produces an average 10% annual return, you'll end up with $445,469. That doesn't sound bad, until you find out that a fund with similar returns but that doesn't charge a sales load will leave you with $486,582 -- more than $41,000 in your final nest egg.
Most people aren't able to start saving early enough to go 40 years before retiring. If you get a late start but make up for it by making a greater contribution, the consequences of a sales load are even larger. Invest $5,000 per year for 30 years, and the difference in total return between a fund with a load and one without a load comes to that $76,901 figure.
Even with the costs of sales loads, millions of people pay them. American Funds are one of the biggest and most popular providers of mutual funds that routinely charge sales loads, but you'll find big companies such as Eaton Vance, Franklin Templeton, Janus Capital, and Legg Mason among the many other fund managers charging them.
How to handle this common problem
The simple solution to expensive sales loads is not to pay them. Plenty of no-load mutual fund and exchange-traded-fund options are available, with many discount brokerage companies even waiving the usual commissions to buy and sell ETFs.
Even better, many of the annual expenses of no-load funds and ETFs are cheaper than funds with sales loads. For instance, to get broad-based exposure to stocks, the SPDR S&P 500 (NYSEMKT:SPY), Vanguard Total Stock Market (NYSEMKT:VTI), and Schwab US Broad-Market ETF (NYSEMKT:SCHB) all offer similar cross-sections of the U.S. stock market. Other low-cost alternatives cover other markets, with the Vanguard Emerging Markets ETF (NYSEMKT:VWO) and similar offerings from other providers covering high-growth foreign stock markets. It's easy to put together your own portfolio of no-load funds and ETFs, and it costs you a lot less to boot.
Don't let an easy-to-avoid mistake cost you $76,901. By steering clear of sales loads, you'll keep more money in your pocket where it belongs.
Fool contributor Dan Caplinger owns shares of Vanguard Emerging Markets ETF. You can follow him on Twitter: @DanCaplinger. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.