If you’re a passive investor, you will probably agree that investing costs are something that should be cut, slashed and minimised.
But did you know that slashing costs can be far more profitable than generating higher returns on your underlying investments, particularly on a per-hour basis?
This article will examine the science of cost cutting and explain why this is happily the case. Read on to find out more on this interesting topic.
In this article, I talk about investing costs. I mean for this to be a broad term that covers an array of fees or taxes which erode the value of our investment portfolio. These could include::
- Investing platform quarterly/annual charges
- Investing platform charges on assets under management
- Fund manager annual management charges
- Dealing / trading costs
- Taxes on capital
- Taxes on dividends, rent and other income.
The Case for Cutting Investing Costs
In my other writings, I take pains to accept that yes, reducing fees may not be as exciting as generating a trading profit. It’s not exactly an adrenaline-fuelled affair. However, savings can flatter your investment returns all the same, and that’s the bottom line.
My personal motto is ‘An investing cost is an investing loss’. A negative spin on the above!
We are usually averse to losses. Let’s be just as hostile towards fees, as they also eat away at our assets and hamper our progress towards financial goals.
Most finance bloggers like to demonstrate the massive impact that fees can have on a portfolio by comparing an investment portfolio’s performance with and without fees.
A different way to look at the topic is to see any cost savings as an incremental income stream in it’s own right. After all, saving $200 and earning $200 has the same impact on your account balance, so why not flip your perspective on its head?
Measuring the Epic Windfall of a Fee Saving
For example: imagine that your stockbroker charges you $400 each year in account fees and platform fees. You could possibly switch to a lower-cost broker who would only charge $300 per year. It’s a noticeable difference, sure, but it would also be an effort to switch and you’re not sure it would be worth it.
Let’s apply the new income mindset. You’re no longer cutting $100 of cost, but creating an income stream of $100 per year if you made the switch.
That ‘per year’ bit is very important.
Because cost savings are linked to periodic fees, you are essentially ‘locking’ them in for the foreseeable future.
So you haven’t just earned $100 this year, you’ve also earned it next year, and the year after, and so on. The savings will last as long as your old provider doesn’t lower its fees (unlikely!), or you abandon your account.
You can take the income perspective further by valuing the lifetime impact of this stream of savings. I like to do this by calculating the ‘present value’ of the income stream. This gives the most meaningful measurement, because it tells me what value I have created today by unlocking this cost saving for the next 20 years.
Twenty years of $100 annual savings comes to a total of $2,000. The present value of this risk-free series of savings in today’s money is approximately $1,488 (using a 3% discount rate).
If you’re not familiar with the time value of money, and how discounting works, then I recommend you master this topic with further reading. The Corporate Finance Institute has a clear and helpful introduction to this topic on their website.
So in this example, making the switch would provide you with a benefit worth $1,500, to be enjoyed over the next 20 years of investing. Is it worthwhile making the switch now?
Investment Returns V Cost Savings
I also hint above at the second advantage of cutting costs; they’re virtually risk free. This is because they’re contractual and don’t tend to fluctuate in value year-on-year.
In other words, a fee reduction will provide a reliable uplift to your returns during both good times and the bad.
As a rational investor, a guaranteed $100 annual saving is worth more to me than an investment strategy that should provide an additional expected return of $100 per year.
The way I could show this is to run the present value calculation again. While the fee saving is worth $1,488 today, I would need to use a higher discount rate to calculate the present value of an additional investing return of $100 per annum.
If I use a discount rate of 7% – a typical reflection of stock market risk, the present value becomes only $1,059.
This shows that a $100 annual saving is simply more valuable than a $100 trading profit each year.
Of course, reducing investing costs and generating additional returns are by no means mutually exclusive. You are probably engaged in doing both.
However, we all have a limited amount of time, energy and attention to give to our investments. Therefore, the way we prioritise these two different objectives can really impact the results we see.
I hope that this article has encouraged you to focus your time on cost savings over seeking ‘premium returns.’ Because cost savings are automatic and risk free, you’ll get a far higher return on your time investment by becoming a cost cutter!
Things to Do
To take action on the ideas in this article, you could do the following:
- Have a think about the cost savings that you have unlocked recently. What did those savings look like as a future income stream?
- Use an online calculator to calculate the present value of this saving and marvel and at the excellent return on investment for the time it took you to achieve the cost-saving. How much did it pay you per hour of your time?
Look ahead and plan your next cost-saving. Perhaps you’re aware of a way to make a small saving that you didn’t think was worth the effort. Now that you can see the present value of the saving – does that change your mind?
Simon writes for Financial Expert, an online investment education website. From investment basics to advanced risk management, Simon covers topics in a step by step fashion, approaching old wisdom and ‘settled arguments’ with a fresh perspective.