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Tuesday 8 October 2019

Compound Interest Works Better Without A Financial Adviser

Hey, hands off my money!
Yeah, yeah, we all know the drill. Start early, be consistent, give it time, and then allow the jet fuel known as compound interest to blow your socks off. The legend is indeed true - compound interest is a really powerful force which can do wonders for a financial freedom dream (or any other long term financial goal).

But what if I told you there was a way to make compound interest even more powerful – compounding your compounding as it were?

Okay, time to meet the Smiths, a couple who have managed to carve out R5,500 a month from their budget. They have decided that they aren’t getting any younger, and they want to put this money towards their retirement.

So let’s walk with them down the road many people would take when faced with this situation – first up, they find a financial adviser. Maybe it’s the one that their parents used, or maybe its their friend's connection, or maybe they do a Google search.

Either way, they find someone and arrange a meeting with them so they can get their investment up and running.

Now, let’s say this adviser is actually semi decent, independent and not just after fees. The adviser realises that because both the Smiths have a pension fund at their work, it is probably better to diversify their tax treatment a little bit, while at the same time getting them some additional offshore exposure, by putting them in a TFSA (and not an RA - see I told you the adviser wasn’t just fee hungry).

And would you look at that - it just so happens that the R5,500 the Smiths have available to invest is the exact amount they need to max out two TFSA’s. Wow what a coincidence!

Okay, let’s assume the adviser puts them in a cheap, passive, equity focused, offshore investment (maybe something like the Satrix World – I say again, this adviser is a good one!) which gets them a 12% annual return. Lets say the adviser takes what seems to be the industry standard fee of 1% per annum (with VAT included that equates to 1.15% per year).

Right, so nothing unusual about any of this, and off the Smiths go on their investment journey.

15 years pass, and in that time, the usual market crashes and recoveries happen, maybe the Springboks win a world cup, and I even get round to finally fixing the light my wife keeps nagging me about.

The Smiths' TFSA investments end up at a combined value of R2.347 million. Not too shabby!

Okay, now let’s consider another path the Smiths could have taken. You see I forgot to mention that Mr. and Mrs. Smith have been a little stressed out lately and they could really use a holiday - and we talking international!

So instead of starting their investment, they decide to stash their money away for 6 months. They then take the R33,000 they have saved up, and go on an epic overseas trip.

But something else happens in the 6 months that they are saving for the holiday...

Mrs. Smith starts listening to the Fat Wallet podcast every Monday on her way to work. And Mr. Smith spends about 30 mins a week reading up about investing on news sites, googling the stuff he doesn’t understand, and even starts following some personal finance blogs (okay maybe I am a little bias, so I had to throw that last one in there ;)).

Little by little, the Smiths start gaining some knowledge. It doesn’t feel like it, but small incremental gains each week results in them accumulating a decent amount of investment smarts.

They learn things like:
  • For a long term investment, you need to have some growth assets like equity.
  • Diversification is important as it can reduce your risk and enhance your returns.
  • Passive ETFs are low cost, and because they track the market, they don’t run the risk of under performing the market.
  • A TFSA can be a great alternative to an RA.
  • When investing for the long term, you need to ignore the media noise and prophets of doom. Markets go up and markets go down - selling when markets are down is a terrible idea.
  • Patience is important, and it’s the time in the market that counts.
After their holiday, (a full 6 months after the scenario where they started investing through a financial adviser) they finally open their TFSA accounts themselves and start DIY-ing their R5,500 a month investment.

Now, bearing in mind that starting early is one of the most important factors when it comes to investing, and in the second scenario the Smiths have lost out on the first 6 months of contributions and growth, do you think their investment would be worth more or less than the first scenario where they started immediately (but used a financial adviser)?

Well, the results are in…

Drum roll please (click for a larger image)…

Yes that’s right, despite starting later (and losing the most important first 6 months), contributing less, and having the investment run for a shorter period of time, the Smiths ended up R100k better off than if they started immediately though an adviser. (R100k - that's enough for some more international holidays in retirement!)

The main reason for this is due to the R154,000 in fees the Smiths would have paid for using the financial adviser. You see, compound interest gets some rocket fuel when there is no drag of an adviser charging a percent based fee. And remember,when it comes to fees, it’s not just the money that gets paid over, it is also the lost compounded growth that money would have had if it had stayed invested instead.

Compound fees are the nemesis of compound interest!

Yes, I get it - investing can get scary, especially when the markets pull a wobbly, or the returns go nowhere for 5 years (I won’t mention any names *cough* JSE Allshare Index *cough*). In times like these, you can call up your adviser and they will tell you don’t worry, everything is going to be okay, just keep at it, this is pretty normal and par for the equity investing course.

For many people, this can be really reassuring. But you got to ask, is it worth paying away R100k for? Heck, drop me a mail and I will tell you all those things for free!

But maybe I am being too harsh. Maybe there is a middle ground to the fee versus guidance issue?

Well, I think there might just be.

Allow me present one more scenario to you.

Hacking The Financial Adviser System

To understand how you can get the best of both worlds (some guidance to get your investment up and running, as well as no paying too much in fees), let’s first take a look at the Rand value the Smiths would have paid in fees for each year that they used a financial adviser (click for a larger image).

Interesting, that looks a lot like a compounding chart, doesn’t it?

Well, that’s because it is!

And this is the problem with percentage fees – as your investment grows exponentially, so too do the fees!

In year 1, the Smiths would have paid a very palatable R428 in fees. But in the last year, they would fork out over R25,000! Eina!

In fact the fees paid in the last year alone would be more than the combined fees of the first 7 years!

And remember, I am only showing a 15 year time-frame, if this investment runs longer (as many retirement investments will) the fees will continue their exponential march till they get to the moon, circle round and then bite the Smiths in the ass!

So here is what I think a good compromise is for someone who wants to start investing, would like the guidance a financial adviser can provide, but is maybe put off by paying too much because of percent based fees.

Let’s see what happens if the Smiths set up their investment through a financial adviser, and then during the first 3 years, while the adviser's fee is reasonable, the Smiths gain some investing knowledge, start understanding how it all works, and then take over the investment themselves at the start of the fourth year.

This is what their investment would look like (versus the scenario where they went on holiday and delayed their investing by 6 months). You can click for a larger image.

In this scenario, they end up with over R2.6 Million. That’s more than R150k better off than if they went on holiday and delayed their investment by 6 months, and a full R250k better off than if they had kept the adviser for the full 15 years.

Now I don’t know about you, but taking some time to learn a little bit about investing seems like a small price to pay in exchange for R250k? And doing it at a leisurely pace over 3 years doesn’t seem like that big a ask at all?

Okay let’s wrap this all up real quick by summarising the investment outcome, contributions made, and fees paid for each of the three scenarios (click for a larger image).

Investing through a financial adviser results in an ever growing and compounding fee bill, as well as some serious lost growth on the money that was paid away in those fees.

The Smith's investment outcome was significantly improved by taking some time to learn how to DIY their investment. This skill is so valuable that they were able to achieve a better outcome even after missing the most beneficial first 6 months, going on a holiday instead, and contributing less in total.

But the best scenario is the case where the Smiths start their investment immediately through a financial adviser, but then go it alone after three years. Yes there are some fees to pay, but that number doesn’t even register on the chart above. And it is this scenario which I think pretty much sums up everything I want to say:

  • Starting early (as in right now) is super important.
  • It’s so important, that even if it means starting your investment by using an adviser, then that is fine! But…
  • … once your investment is up and running, costs become really important. Spend some time to educate yourself, because percent based fees quickly become a total rip off, and learning to invest on your own could be one of the highest paying skills you will ever learn.
Yes, it's true - you are not going to learn everything there is to know about investing overnight. But by putting in a little bit of effort on a regular basis over an extended period in time will prove to be well worth the 6 or even 7 figures you can save in fees.

Till next time, Stay Stealthy!
 - ~ - ~

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