Say I give you a dollar for your birthday.
Then I tell you each year I'm going to double it.
Next year I'll give you two dollars, the year after will be four dollars, then eight dollars and so on.
How much do you think I'll be giving you on your 21st birthday?
Most people usually guess $100,000 or so.
This is because people underestimate the power of compounding.
If you do the math, you'll see that I would be giving you over $1 million dollars on your 21st birthday ($1.048 million to be exact).
Now here's a twist.
How much do you think that figure would change if instead of giving you $1 on your first birthday, I gave you 95 cents.
You might be thinking, that's just 5 cents, it will hardly change anything.
But that 5 cent loss, compounded over 21 years, will add up to over $50,000 less on your 21st birthday.
Take a look:
Year | $1 doubled each year | 95 cents doubled each year |
---|---|---|
1 | $1 | $0.95 |
2 | $2 | $1.90 |
3 | $4 | $3.80 |
4 | $8 | $7.60 |
5 | $16 | $15.20 |
6 | $32 | $30.40 |
7 | $64 | $60.80 |
8 | $128 | $121.60 |
9 | $256 | $243.20 |
10 | $512 | $486.40 |
11 | $1,024 | $972.80 |
12 | $2,048 | $1,945.60 |
13 | $4,096 | $3,891.20 |
14 | $8,192 | $7,782.40 |
15 | $16,384 | $15,564.80 |
16 | $32,768 | $31,129.60 |
17 | $65,536 | $62,259.20 |
18 | $131,072 | $124,518.40 |
19 | $262,144 | $249,036.80 |
20 | $524,288 | $498,073.60 |
21 | $1,048,576 | $996,147.20 |
TOTAL | $2,097,151 | $1,992,293 |
You can also see that over that 21 years, you would have collected $2.097 million from me.
But if I had given you 95 cents in that first year instead, you would have only collected $1.99 million.
That's over $100,000 in difference, from a single 5 cents.
Management fees are like small losses, compounded over many years
When you invest in Kiwisaver, or an ETF, or a managed fund, you pay a management fee.
I have always drilled into the readers of this blog that these management fees are of utmost importance.
You must always check the management fees before investing in any fund, because they can literally end up costing you millions of dollars.
Let's take Kiwisaver, for example, since this affects most New Zealanders.
Right now, the cheapest Kiwisaver fund available is Kernel. They have a fixed management fee of 0.25%.
One of the most popular Kiwisaver funds is Fisher Funds.
Their growth fund has a management fee of 1.02%.
Upon seeing this, most people might think, oh it's half a percent or whatever, who cares.
But this could literally cost you millions of dollars over your lifetime.
Don't believe me?
How much fees can change your returns
People usually put a minimum of $1,042 into Kiwisaver each year, and the government adds an additional $521, which is an annual contribution of $1,563.
What would the difference be if we invested in the Kernel Growth Fund, with an annual fee of 0.25%, versus the Fisher Growth Fund, with an annual fee of 1.02%?
Let's assume the average person works for 50 years before retiring, and a growth fund returns 10% per year on average.
Returns with a 0.25% annual fee:
Using our compound interest calculator, if we contribute the minimum $1,563 to our Kiwisaver each year for 50 years, returning 9.75% per year (10%, minus a 0.25% fee), we'll end up with just over $2 million:
Returns with a 1.02% annual fee:
Using our compound interest calculator, if we contribute the minimum $1,563 to our Kiwisaver each year for 50 years, returning 8.98% per year (10%, minus a 1.02% fee), we'll end up with just over $1.5 million:
When investing in the low fee fund, you end up with $2.048 million.
When investing in the high fee fund, you end up with $1.508 million.
This means simply choosing a fund with bad fees costs you more than half a million dollars by the time you get to retirement!
Compounding works wonders and will make you incredible amounts money over time.
But it also works in reverse and will lose you incredible amounts of money over time.
Let's take it even further.
Here at @moneybren, we do a lot more than Kiwisaver.
My goal is to teach you to build a million dollar portfolio and retire early, and to do that, we need to invest a lot more than $1,500 per year.
Let's use the same two funds, but this time we're investing 50% of our income, and we're on minimum wage.
This will work out to around $1,500 invested per month.
Using our compound interest calculator, if we invest $1,500 per month for 50 years, into a Kernel fund with a fee of 0.25%:
Not bad!
Investing diligently for 50 years on minimum wage will get us to around $23 million over a lifetime.
What about with a higher fee?
Using our compound interest calculator, we get the following after 50 years when investing $1,500/month in a Fisher Growth fund with annual fees of 1.02%:
Choosing a 1% fund versus a 0.25% fund literally will cost you more than $6 million dollars over a lifetime.
Now of course, we're presuming a few things here.
First, we're assuming the Kernel Fund and the Fisher Fund have the same returns.
This may not be true, because the Fisher fund is an active fund, and the Kernel fund is a passive fund.
However, historically speaking, more than 80% of active funds actually underperform the market.
Secondly, it's usually active funds that have higher fees, which gives you even more reason to choose a low-fee, passive index fund.
Either way you slice it, high fee funds are very rarely worth the extra money.
Compounding is fantastic, but never forget that it works in reverse as well.
When trying to choose between two funds and the management fees are 0.1% versus 0.5%, don't write that difference off.
It could literally cost you millions over a life of investing.
How Do I Know What The Management Fee Is?
In New Zealand, by law all fees need to be disclosed.
While there are a variety of fees, generally, it's the management fee you need to worry about, as this is charged as a percentage of your assets, so it has a compounding effect.
Administration fees are slightly different, and are usually a nominal amount (e.g. $2 per month).
There is usually very little consequence between $1 per month versus $2 per month.
However, there is very big consequence between 1% per year versus 2% per year.
To find a fund's management fee, simply pull up the fund details at the fund provider.
For example, here is the fund details and management fee details for the Fisher Growth Fund:
Here is the fee disclosure for the Kernel Growth Fund:
Here are the fee details for the Smartshares S&P 500 fund:
Also remember that NZ fund fees are high in general.
If you are able to invest in Australian dollars, you will find ETFs have far lower fees.
For example, the S&P 500 ETF on the Australian stock exchange (iShares IVV) has an annual management fee of 0.03%.
That's about 10x cheaper than an NZ based fund!
This will vary between personal circumstances, but if you're in a position to invest in an Australian based fund over an NZ based fund, it might save you a million or two by the time you retire.
Looking to buy your first index fund? Check out my guide on buying your first $100 in stocks here.