Describe why it is just as important to evaluate brokerage or management fees as it to evaluate the total return on any investment when investing.

Question

What will be an ideal response?

Answer 1

Fees are charged for every investment. Your broker may charge a fee every time you buy or sell a stock, bond, or mutual fund. Funds themselves may also have fees attached, since somebody has to manage the funds, collect the money, invest the money, supply the paperwork, advertise the funds, and so forth. You will never eliminate fees entirely, but you can avoid paying higher fees than are necessary. It is not uncommon for a broker or a fund to charge a 2% management fee. These 2% fees are avoidable, because plenty of other brokers charge less, or you can purchase funds directly that charge a minimal management fee. While the fund or your broker wants you to look at overall performance (growth in value each year), you should deduct the fees from the overall performance to determine the actual return on your investment. For example, you want to have $1,000,000 in 40 years. If you assume a 10% return, you will need to invest just $158 per month. But, what happens if you are paying a 2% fee each year? First, understand that a 2% fee on a 10% return is actually a 20% fee on the returns (2% / 10% = 20%). Anytime someone is earning 20% commissions (or you are paying a 20% fee), that investment costs a lot of money. Since you earn 10%, but pay 2%, you earn a net of 8% (10% - 2% = 8%). If we plug 8% into our TVM calculations instead of 10%, that $158-per-month investment just increased to $286! The 2% fee just cost you nearly $130 per month! Looking at it another way, you have to invest 81% more each month because of a 2% fee. Think about it another way. If you start with $10,000 invested and the return is 10%, you should have $11,000 in your account. But, if the brokerage firm charges a 2% management fee, they will deduct $200 ($10,000 × 2% = $200), leaving you with only $10,800 ($11,000 - $200 = $10,800). The next year, instead of earning 10% on $11,000, you will only earn 10% on your balance of $10,800, plus pay the 2% fee, and so on.