Human beings are poorly wired to be good investors. We have many deep-seated biases and behaviours that, while once useful to survive in the wild, do us a great disservice when investing. One area of weakness is our poor grasp of the exponential impact of compounding that can work both for and against us.
Imagine three different portfolios that deliver returns of 1, 3 and 5 per cent per year after inflation, but before other costs, over a period of 30 years: £100,000 invested in each would result in a growth of purchasing power to around £135,000, £240,000 and £430,000 respectively. Seemingly small differences in the compound rates of return, turn into large differences, in terms of financial outcomes.
On the other side of the coin, costs – when compounded over time – eat away at these market returns to a far greater degree than many investors imagine. Unfortunately investors fail to consider the severe deductions from long-term wealth of the costs they suffer. A pound of costs saved is no different to a pound of market performance in monetary terms, yet it is far more valuable due to its consistency over time and the fact that it is achieved without taking any more risk.
Multiple research sources identify the fact that low costs drive higher performance outcomes. The use of low cost products to implement an investment strategy provides a meaningful performance advantage over higher cost alternatives.
It would be worthwhile paying higher fees to invest in a fund managed by a uniquely talented manager who can deliver returns above the market after all costs – if we can be certain that their performance is due to skill and not luck (you need around 20 years of track record to split one from the other) – and if we are confident that they will consistently deliver market beating returns into the future. Unfortunately those are big ‘ifs’ with little supporting data. In the absence of that level of certainty, focusing on managing investment costs as tightly as possible makes good sense.
Investing in a systematic low cost manner, where product providers have due regard to the costs that investors suffer is very effective. Ensure that you are aware of the effect of investment fees on your own portfolios.
To discuss our disciplined approach to investing, please contact a member of our adviser team on 020 7636 7006.