Most investment costs are bundled in with the financial product, and are often hidden in fine print, warns Erik Hon.
Illustration by Uttam Ghosh/Rediff.com
When we talk about the power of compounding in investments, we’re usually only referring to the compounding of returns: the sooner we start saving, the longer our money is able compound and grow.
But there is another factor in investments that compounds with equal force, and one which we ignore to our own great loss -- the cost of investing.
The cost of any investment is the amount that is not invested on our behalf, but is deducted from the invested sum to cover a variety of things like transaction/processing fees, administration or management fees, commissions, brokerages, transaction taxes, and even marketing fees for the product we are investing in.
Most of these costs are bundled in with the financial product, and are often hidden in fine print.
Which means that, unless we’re paying attention, we don’t realise that all of our invested money is not actually working for us.
Also, the costs mentioned in the prospectus are usually figures like 0.5 percent or 1.25 percent, and these may seem too miniscule to worry about. But this is where we fail to account for the compounding effects of these costs and don’t realise just how much we’re losing.
The late John Bogle, legend of low cost investing, estimated that hidden costs can eat away as much as 2/3rds of our returns over the long term.
Let’s consider this:
If you invest Rs 1,00,000 for 25 years, and earn returns of 7 percent a year, with no costs or fees, you would have over Rs 5,42,000.
Now, if we assume that your total costs of investing for this period come to 2 percent per annum, at the end of 25 years, with the same investment, you’d have a little over Rs 3,38,000. That’s over Rs. 2,04,000, or 37 percent of earnings lost in costs.
Multiply this effect over numerous investments and we start to see why costs are a big deal.
Read on to know three ways to minimise your investment costs, and maximise your returns.
1. Make informed product choices
All financial products, be it stocks, bonds, mutual funds or insurance have costs attached to them.
Different products have different cost structures depending on various factors such as the distribution channels, types of products and remuneration structures.
Let’s take the example of insurance. Insurance policies have one of the least transparent cost structures because of the complex calculations of risk, duration of coverage and amount of cover involved.
It is also a product with fairly high distribution costs (commissions for insurance agents) built in. However, with insurance companies selling policies directly, investors can find significantly lower premium policies online.
For example, the premiums for online term plans are 30 to 50 percent lesser than the premiums for offline term plans, for the same policy and coverage, primarily because there are no distributor or intermediary charges to be paid out.
In addition, bundled insurance products where insurance and investments are provided such as a whole life plan, unit-linked plan, endowment plan and money back plan, are more expensive than the plain vanilla term life plan where only insurance is provided without any investment component.
It makes sense to go for the unbundled product like the term life plan because there are many cheaper alternatives to invest and accumulate wealth than to invest through insurance products.
Mutual funds too have ‘direct plans’, which are plans without any distribution cost attached, and have much lower expense ratios as compared to regular plans.
Mutual funds also have ‘passively managed’ variants like Index funds and Exchange Traded Funds (ETFs) that track an index and thus require lesser fund management effort.
Such funds cost far less than the actively managed funds: SEBI’s total expense ratio (TER) cap for index funds and ETFs is 1 percent, compared to 2.5 percent for other equity oriented mutual funds.
Of course, costs should not be the only, or even the first consideration when selecting an investment product.
However, it helps to be aware of the underlying costs that get added on to products and compare that with the quality of advice and service we receive in return.
In most cases, it is cheaper in the long run to go with a fee-based investment adviser who does not earn commissions on investments made.
These are professional, qualified advisers who will help you invest in investment products that are best suited for your financial needs, while also ensuring that your costs are minimised as far as possible.
2. Invest, don’t trade
There’s a very good reason why some of the most successful investment advice has to do with investing for the long term.
Every transaction involves a cost, so the more you move around your money, the more you lose in costs.
The higher your returns need to be to simply recover that lost ground.
This is one of the biggest reasons why, over the long term, very few actively managed funds manage to show returns above the market index, while the cheaper passive funds, which perform at par with the index, prove to be better bets for investors.
Being able to follow a focused, disciplined investment plan also depends on whether you have a plan to begin with.
Following ad hoc investment tips, and accumulating investments without a planned asset allocation or goal based strategy often leaves you confused and nervous about every market fluctuation.
Qualified financial planning or investment management advice can help you start off on the right note with a diversified portfolio that can withstand short term market volatility.
Sure, you will need to pay fees for such advice, but if it saves you from compounding losses with unnecessary cost, the professional advice will have paid for itself in real money terms in the long term.
3. Know your tax
Tax implications of investments are often complex and obscure, but are still worth knowing about as they lead to efficiencies and savings that we may be unaware of.
Especially when investing for long term goals like retirement or wealth transfer to the next generation, choosing tax efficient investment products can make a lot of difference.
We also have the benefit of investing in a very tax friendly capital market. Because Indians retail investors have been fairly shy of investing in the capital markets, the government tries to encourage this through favourable tax laws on capital market products.
For example, capital gains on equity sold after more than a year (shares or mutual funds) are tax free up to Rs 1 lakh, and taxed at 10 percent beyond that.
Similarly, dividend income from shares and equity mutual funds are exempt from tax.
In a nutshell, investing is a 20-30 year long activity in most of our lives.
Losing sight of the costs we incur along the way can seriously undermine our wealth creation effort.
Asking the right questions and working with the right adviser can ensure that the money we invest is actually working for us.
Erik Hon is managing director, iFAST Financial India Pvt Lt, a digital multi-asset advisory platform for investment advisers.