The Law of Compounding Makes Fees Quite Sizeable Over Time

Many do not flinch at paying 1-2% of their asset in fees to a financial advisor, but if one were to better understand the Law of Compounding one might look at 1-2% differently. The Law of Compound Returns is a force of nature. Simply put, the Law of Compound Returns says money left alone creates more money. Understanding this concept is critical to your success as an investor; An Investing 101 term worth understanding.

Wall Street interrupts the Law of Compound Returns. Wall Street would have you believe that you need to interrupt this force of nature with heavy-handed human intervention and hefty costs that drain away your investment. Working counter to the Law of Compound Returns, Wall Street dooms you to failure. But it will succeed in taking your money-if you let it.

So what is one to do? Investing in low cost index funds, ultimately exchange traded funds, and taking on a more passive investment style will allow your money to grow efficiently-without the oversized management fees and tax implications that are Wall Street’s bread and butter (and caviar and steak). Diverting the 1-2% you have paid in fees over the years into your own pocket will over time be a substantial gain for you.

An example of compounding:
Let’s say you are 40 years old and invest $100,000. You earn a 9% return the first year, so now you have $109,000. You reinvest your $9,000 and it continues to earn 9%, so you have $118,810 by the end of the second year. If your investment keeps growing at 9% (and you don’t withdraw any of the gains), your money starts growing at an astounding rate.* The same holds true for the 1-2% you would keep by managing our own money. The percent itself may seem small but over time is significant in savings.

So for all you beginners to ‘do-it-yourself investing’, look to building a portfolio of low cost index funds or ETFs. With a good asset allocation and attention to rebalancing your portfolio as needed, you will benefit with more retirement dollars to spend in the future than if you hired an advisor to manage your money for you.

* Of course 9% is just an example, but it is consistent with the average annual compounding rate of the U.S. stock market over the past (80) years.