Are costs ruining your portfolio party?

Successful portfolio management is a dance between risk, return, and cost. Risk and return make great dance partners while cost is the obnoxious drunk who tries to butt in. Investing becomes a beautiful thing when this drunk gets booted from the party, but unfortunately, in today’s investment world, it’s up to you to be the bouncer.

Many investors are shocked to learn that an apparently small annual portfolio cost of 2% will likely result in a 40% loss of wealth over twenty years. How could what looks to be such a small fee result in such a deleterious effect? A brief explanation may help.

For discussions sake, if you accept that a globally diversified portfolio across stocks and bonds will historically return around 8% annually, then 2% in fees represents a 25% tax on profits. Think of it this way. For every portfolio dollar earned, you are paying your investment partners twenty-five cents via seen and unseen fees lurking in your portfolio. Extrapolate this impact out over 20 years and you can watch your net worth shrivel before you eyes.

And, shockingly, a 2% fee drag is easily achieved in today’s wealth management marketplace. According to 2010 research performed by PriceMetrix Inc., the average annual fee collected by advisors on managed accounts was 1.32%. Furthermore, most of the dollars within these accounts were directed into mutual funds whose annual costs, according to studies, averaged 1%, a 2.32% annual bummer.

While some might argue that having drinks on hand is essential to a great party, everyone knows that a belligerent drunk quickly ruins an event. Likewise, fees are essential to investing, and you don’t want to hesitate paying for quality services and products. But when costs reach 2.32% they are out of hand and it’s time to call in the bouncer and clean up your portfolio act. Here is what to look for.

The cost of advice : Paying for investment advice makes a lot of sense for the majority of investors. A recent study by N. Scott Pritchard based on Dalbar research demonstrated that due to the erratic fear and greed based trading, the average investor underperforms the S&P 500 index by 6% annually. For this solitary reason, many will find the cost of going it alone is too high to bear. It behooves investors to take a hard look and decide if they have what it takes to do the long-term work of portfolio management without adult supervision.

This does not mean, however, that an investor should pay 1% for advisory services. One option for investors is to find an independent fee-only financial planner or investment adviser. For instance, the Garrett Planning Network has a nationwide association of professionals who are closely aligned with your interests and seek to make competent and objective decisions on an hourly, as-needed basis.

Additionally, you can also turn to one of several quality firms like Portfolio Solutions that will manage your low-cost and globally diversified portfolio for .25% annually. Or to firms like, MarketRiders, that will managed an account annually for a low fee annually. Getting professional advice can make a lot of sense, as long as you pay a reasonable rate for smart guidance.

The cost of your funds : The mutual fund promise is that high fees will be overcome through the outstanding performance of their funds. Sure, you will pay your annual 1% or more for fund participation, you will additionally pay hidden 12b-1 marketing fees, and you will experience difficult-to-track fees in the form of taxes that result from churn within the fund. But fear not!

Unfortunately, a closer looks at mutual fund performance over the decades should leave you with a different motto: Fear this!

Research has repeatedly demonstrated that mutual funds underperform their benchmark. At this point, this news has becoming so tragically boring that many seem to no longer be listening. Sadly, year-upon-year, a new batch of investors willingly piles off the mutual fund cliff and into the sea of high fees and poor returns. Those in the know remain bewildered as they look upon these sad lemmings plunging to their investment demise.

Smart investors looking to pay costs commensurate with value should look to low-cost Vanguard index funds and quality exchange-traded funds. These funds are essential building blocks for portfolio management and can now be had for absurdly low costs. Take, for instance, Vanguards S&P 500 Index Admiral Shares VFIAX -0.33% . This essential building block costs a meager 0.05%annually. A host of remarkable, low-fee ETFs from iShares, State Street Global Advisors, Schwab and more are also available to address your needs.

While risk and return make fabulous dance partners within your portfolio, keep a watchful eye on the belligerent party pooper — cost. If you’re a diligent bouncer and keep cost under control, you’ll be dancing with the stars in no time!