The 2% That Will Kill You (And It Ain’t Milk!)

The 2% That Will Kill You (And It Ain’t Milk!)

This post is about two little percentage points that can drastically alter your financial destiny.   And while they might not literally kill you, they actually can kill your chances of an early retirement.

I first heard this concept months ago while listening to a Choose FI podcast.  I’m not sure what episode it was (since there are so many now), but I want to be sure to give them some credit for the idea.  When I first heard them discuss this, it was so jaw dropping that I knew that one day, if I ever started a blog, I would have to write about it and discuss it in further depth.  Well, this is that day.

Our Scenario

It starts out something like this.  Let’s start with a hypothetical example of a 25-year old that has $100,000 in cash.  I know, I know, that is not the norm and would be quite exceptional.  But it is possible.  Let’s say she was a very motivated and financially savvy individual.  She goes to college on a full academic scholarship immediately after high school from the ages of 18-22 and does not accumulate any student loan or credit card debt.  In fact, she works part time during school and is able to save $2,500 per year, for a total savings of $10,000 when she graduates.  She then gets an excellent job with her degree that pays the American median salary of $60,000 per year.  She is a super saver and saves half of her income ($30,000) each year for the next 3 years.  This would make a total of $100,000 by age 25.  

So, yes, it is possible.  Perhaps, another more likely scenario is a 25 year old that receives an inheritance of $100,000 from a grandparent.  Either way, the point is we have a 25 year-old with $100,000 in cash.

Now, let’s say that 25 year-old has discovered the Financial Independence (FI) movement.  She reads The Simple Path to Wealth by J.L. Collins and decides she is going to invest the $100,000 in a passive low-cost total stock market index fund.  Next, we’ll assume the market returns 8% for the next 40 years.  While optimistic, this is possible.  From the same book we learn that the market returned 7.8% from 1975 to 2015 with dividends reinvested AND adjusting for inflation.  What happens if she doesn’t touch that money for the next 40 years?  We’ll assume she loses her lust for investing and never even adds to it, she just lets it ride.  For simplicity, we will also ignore the 0.04% expense ratio the fund charges and any taxes.  Using a compound calculator, here is what it would return:

$2,172,452.15

Wow!!!

That is a lot of money.  Over 40 years, she earns more than $2 million in interest.  If that doesn’t demonstrate the power of compound interest, then I don’t know what does.  

The First 1%

Ok, now let’s add a little twist to our story.  Let’s say our 25 year-old hasn’t been studying any personal finance.  She has heard from her parents and peers that investing is complicated.  Based on her current financial paradigm, she believes that a professional is required to help invest this large sum of money.  So she decides to hire a financial advisor.  

Let’s assume that this financial advisor charges her a 1% assets under management annual fee.  This, in fact, is an extremely common way for financial advisors to charge their clients.  It means that every year the financial advisor gets paid 1% of the total value of the managed portfolio.  So, if you have a total of $100,000 invested in various assets, you owe the advisor 1% or $1,000.  That doesn’t seem like too big a deal, right?  It’s just one percent.  It’s probably worth it, especially if you are getting good advice, right?

Well, remember that this is an annual fee.  So she has to pay this each and every year.  Let’s see what that does to her investment.  We’ll assume this financial advisor is pretty good and also recommends the same passive low-cost total stock market index fund, which yields the same 8% return over the next 40 years.  But now she has to pay 1% to the financial advisor each year, which reduces her overall return to 7%.  Let’s see what that does over the course of 40 years:

$1,497,445.78

While still a nice chunk of change, she lost $675,006.37 just to have someone be her financial advisor and keep her invested in a passive index fund that she could have learned about just by reading a book or a few blogs.

The Second 1%

Finally, let’s change one more thing.  What if this financial advisor puts the money in an actively managed fund that charges an expense ratio of 1%, instead of the passive low-cost index fund.  This 1% expense ratio is also actually pretty common as far as actively managed funds go.  

So now she is paying a 1% fee for the fund every year, and 1% to her financial advisor every year.  No big deal right, it’s just 1% a couple of times.  But now this reduces her annual return to 6%.  Let’s see what she earns with a 6% return over 40 years:

$1,028,571.79

This is $1,143,880.36 less than if she had chosen a passive index fund on her own!.  

Holy Moly!  So with just these 2 simple decisions (i.e. mistakes) she has lost more than 50% of what she could have had over a 40 year time horizon.  And that is why THIS IS THE 2% THAT WILL KILL YOU.

Conclusion

So what do we learn from this illustration?  

• The wealth building power of compound interest is nothing short of breathtaking.  To see $100,000 invested grow to more than $2 million over 40 years when just left to compound over time is amazing.  

• Every 1% you lose to expenses and fees has a dramatic impact on your money’s wealth building capacity.  

• Paying a financial advisor can dramatically reduce your investment returns.  Some may argue that investing is too complicated and they aren’t willing to put in the time to learn it.  I would argue anyone can learn the basics of personal finance and investing.  In the above example, the first 1% cost $675,000.  If you took just 12 hours to read The Simple Path to Wealth and some blog posts to learn the basics about index fund investing, that would be a return of more than $50,000 per hour.  In my mind, that is time well spent and no financial advisor is worth that much to me.  

• If you decide you absolutely need a financial advisor, be sure to get one that is a fee only advisor that charges an hourly rate.  It may seem very expensive to pay someone $300-$500 per hour, but it is so much cheaper than paying them a percentage of your future every single year.  

• Investment fees can also kill your investment returns and are important to avoid.  Actively managed funds by definition have fund managers that are actively buying and selling investments in the fund, which costs money.  These fees eat into your returns every year like a slow growing and relentless cancer.  Look at your current investments and see how much you are paying in expenses.

How are you doing on this 2%?  Are you paying someone a percentage of your future every year?  Are you paying for THEIR kid’s to go to college instead of your own?  Do your investments have high associated fees that might force you to work a decade longer than you would otherwise?

Stop being ignorant about your money.  Check out how you are doing on this 2%.  Today is the day you can reclaim control of your finances and accelerate your progress down the path to FI.