Type of costs associated with investing

Type of costs associated with investing

Investing is a crucial component of building wealth and securing financial stability. However, it’s important to recognise that all investments come with costs that can eat into your returns. Many investors often overlook these costs, but they can have a significant impact on your investment performance over time. Understanding and actively minimising investment costs is key to maximising your gains. In this comprehensive guide, we will delve into the different types of investment costs, the impact they have on returns, and strategies to reduce these costs.

Types of Investment Costs

Investments carry various types of costs, and being aware of them is the first step towards managing and minimising them. Let’s explore the different types of investment costs:

1. Expense Ratios: The Cost of Fund Management

One of the most common investment costs is the expense ratio. This is the measure of what it costs to manage a mutual fund, expressed as a percentage. It is worth noting that this cost is not associated with buying single stocks. You could buy every stock there is globally, but at a high cost. The cost of buying a fund means the fund providers buy stocks on your behalf, and you buy shares of the fund at minimal cost. This increases diversification and exposes you to the next ‘winners’.

It is calculated based on the total assets invested in the fund and is deducted from the fund’s returns. A higher expense ratio means a larger portion of your money is going towards management fees, reducing your overall returns. Research has consistently shown that lower-cost funds tend to outperform higher-cost funds over the long term. By opting for funds with lower expense ratios, you can potentially increase your investment returns.

This is usually found in the fund factsheet.

2. Market Costs: The Impact of Trading

Another significant cost in investing is market costs, which are incurred through trading activities. Every time you buy or sell an investment, you may be subject to transaction fees, brokerage commissions, and bid-ask spreads. These costs can quickly add up and erode your investment returns. It’s important to be mindful of the frequency of your trades and consider taking a long-term approach to investing. Think about dollar-cost averaging especially when making monthly savings contributions to your savings plan. Remember, “your money is like a bar of soap—the more trading you do, the less soap you have.

3. Platform Fees: Costs of Account Maintenance

Platform fees are associated with maintaining certain types of investment accounts, such as general investment accounts, ISAs or SIPPs. These fees cover the administrative and reporting requirements associated with these accounts. While they may seem relatively low, ranging from 0% to 1%, they can still impact your overall investment returns. It’s essential to consider these fees when evaluating the costs of different investment options.

4. Advisory Fees: The Price of Professional Guidance

You may incur advisory fees if you work with a financial advisor or wealth management firm. These fees compensate the advisor for their expertise and guidance in managing your investments. Advisory fees are typically calculated as a percentage of the assets under management (AUM). While it’s crucial to seek professional advice, it’s equally important to evaluate the cost-effectiveness of the services provided by your advisor. Comparing advisory fees across different providers can help you make an informed decision.

Good advisors don’t just guide in managing investments. Their expertise expands from behavioural reasons to rebalancing and keeping up to date with tax positions.

To find out more about Private Capital’s value, click here.

5. Loads and Commissions: Buying and Selling Costs

Loads and commissions are fees associated with buying or selling certain investment products, such as mutual funds. Front-end loads are fees charged when you purchase shares, while back-end loads are fees incurred when selling.

Commissions, on the other hand, are fees paid to brokers for executing trades. These costs can vary widely, and it’s important to understand the impact they can have on your investment returns. Considering no-load or low-load funds can help reduce these expenses. Ask your broker if they are conflict-free. Feel free to check out our other article which details questions you should ask your money manager.

At Private Capital, we do not charge front-end fees, back-end fees, commissions, rebates or exit penalties. To find out our ongoing fees, click here.

6. Other Costs: Purchase and Redemption Fees

Some mutual funds may impose additional costs, such as purchase and redemption fees. When purchasing into a fund, the investor receives units. A purchase fee is usually charged to an investor when they purchase units in an investment product, such as a hedge fund. A redemption fee is charged if the investor sells within a certain period, for example, in the first 5 years of holding a fund, there could be a percentage fee charged to the investor, meaning the amount you receive from selling your units in a fund, could be lower than expected.

These fees are typically a percentage of the amount you’re buying or selling and are meant to cover administrative expenses. While they may seem minor, they can accumulate over time and affect your overall returns.

At Private Capital, there are no purchase or redemption fees.

The Impact of Investment Fees on Returns

Investment fees may appear minimal on the surface, but their long-term impact on your investment returns can be substantial. Let’s consider two scenarios to illustrate this:

Scenario 1: Embracing Lower Costs

Suppose you have an investment account worth $80,000 and hold the investment for 25 years, earning an annual return of 7% while paying an expense ratio of 0.50%. At the end of the 25 years, your investment would grow to approximately $380,000.

Scenario 2: Overlooking Costs

Now, imagine the same scenario, but with a higher expense ratio of 2.0%. After 25 years, your investment would only grow to approximately $260,000. That seemingly small 1.5% difference in expense ratio would cost you $120,000 over 25 years.

These scenarios highlight the importance of considering investment costs. Lowering fees can significantly impact your long-term returns and help you build wealth more effectively.

Strategies to Reduce Investment Costs

Reducing investment costs is crucial for maximising your returns over the long term. Here are some strategies to help you lower your investment costs:

1. Buy and Hold: Embrace Long-Term Investing

One effective strategy to lower costs is to adopt a buy-and-hold approach. By staying invested in globally diversified funds for the long term, you can minimise transaction costs associated with frequent buying and selling. Remember, “stay in your seat” and focus on time in the market rather than timing the market.

2. Tax Considerations: Understand the Implications

Taxes can significantly impact your investment returns. Understanding the tax implications of different investment vehicles can help you optimise your tax strategy. Consider tax-exempt or tax-deferred investments to reduce your tax burden and increase your after-tax returns. British expats when leaving Hong Kong, can look to expand their investments when moving back to the UK by opening ISAs or SIPPs which have favourable tax reliefs and exemptions. Hong Kong investors can look to open a TDVC account which offers tax deductibles, more on that here.

Do you know the difference between Irish-domiciled funds and US-Listed Funds? US-listed funds are subject to higher withholding tax on dividends, and higher estate tax. More on this later.

3. Diversification: Opt for Low-Cost, Global ETFs

Diversification is key to managing risk in your investment portfolio. Instead of investing solely in a single market, such as the S&P, consider low-cost, globally diversified ETFs with a broad range of assets in multiple markets. This will give you exposure to multiple different markets which may outperform other markets, capturing returns you may not receive when investing in a single market. These funds offer both lower costs and higher diversification, providing you with a well-rounded investment strategy.

4. Research and Comparison: Find Cost-Effective Investments

Doing thorough research and comparing investment options is essential for finding cost-effective investments. Look for funds with lower expense ratios and consider no entry or exit charges. Take advantage of online brokerage platforms that offer low-cost trading and access to a wide range of investment products.

An example of this is Interactive Brokers, which currently charges a 0% platform fee. A Vanguard mutual fund fee which is Irish-Domiciled varies from 0.05%p. a to 0.29% p.a.

5. Professional Advisors: The value of an Advisor

This may seem counter-intuitive, but there are many added values of having an advisor. A study from Vanguard shows an advisor’s range of potential value added to clients can “add up to, or even exceed 3% in net returns”. This means even paying for an advisor can often benefit you in the long run in scenarios such as rebalancing, asset allocation, and most importantly, behavioural coaching.

In Summary

Lowering investment costs is a crucial step towards maximising your returns and building long-term wealth. By understanding the different types of investment costs and employing strategies to reduce them, you can enhance your investment performance. Remember, time is your ally when it comes to investing, and minimising costs allows you to keep more of your hard-earned money working for you. So, embrace lower costs, stay invested for the long term, and watch your wealth grow over time.