When paying for professional advice, you expect to get some added value. Unfortunately, this is mostly not the case in the financial world. The vast majority of financial professionals are actually sales brokers. They make hefty commissions by selling expensive financial products that are riddled with hidden fees. These fees erode your returns over time and will ultimately destroy two-thirds of your nest egg! In this article, we’re going to pull the curtain off on some common practices in the financial world so that no one could take advantage of you ever again. Armed with this knowledge, learn to avoid overpaying for underperformance and claim back hundreds of thousands into your retirement pot!
1. Fees Destroy Two-Thirds of Your Retirement Investments
Imagine that you have set a course for your boat to your dream destination and it has sailed off into the sunset. However, you’re not aware that your boat has a hole in it. Before you realize it, water starts to leak in and ends up sinking two-thirds of your boat before it reaches its ultimate destination. That’s the kind of damage hidden fees and commissions do to your investments!
Fees and Other Hidden Costs
The average person invests money in a mutual fund that pools money from several investors and is managed by a fund manager. The professional manager actively trades stocks and/or other assets in an attempt to generate returns in excess of those of the market. Obviously, neither the financial firm nor the fund manager works for free. There are in fact layers of fees, operating expenses and other costs related to running a mutual fund. These include upfront sales commissions, management & advisory fees, trading fees, bid-ask spreads, custody fees, legal charges, marketing expenditures, etc…
Wanna guess who pays for all these costs? That’s right, they are all skimmed off your overall investment returns. The problem is that you almost never get to know how much you’re really paying in fees. Even when you look under the hood, the “expense ratio” disclosed in the fund’s cryptic prospectus document does not fully represent your bottom line. There are additional hidden costs that get siphoned from your returns. The following table shows the average annual costs (both disclosed and hidden) associated with US mutual funds. They are expressed as a percentage of the money invested:
| Average Equity Mutual Fund | Percent of Average Assets |
|---|---|
| Advisory fees | 1.1% |
| Other operating expenses | 0.5% |
| Expense Ratio | 1.6% |
| Transaction costs | 0.7% |
| Opportunity cost | 0.4% |
| Sales charges | 0.6% |
| TOTAL ANNUAL COSTS | 3.3% |
The Tyranny of Compounding Fees
Most investors outside the US pay much more than their American counterparts. In the Middle East, for example, the annual fees associated with saving plans and insurance-linked schemes typically exceed 4%! And believe me, I’m being conservative here.
You might be thinking: “What’s 4% between friends? It’s more like a waiter’s tip”. Well, let’s have a closer look. When you pay 4% in annual fees, and assuming your investments are returning an average of 8% per year, you’re practically giving away 50% of your yearly profits to the financial industry!
With 4% in fees, you’re paying $400 for every $10,000 invested per year, every year. This fee is payable whether the market goes up or down. In comparison, an investor in an index fund with a low expense ratio of 0.20% only pays $20 per year for every $10,000 invested.
That’s a 20x difference! To put that in perspective, it’s like if your friend bought a smartphone for $1,000 and you paid $20,000 (20x more) for what seems like the same phone! (more on that later)…
What makes things worse is that these costs compound over time. To illustrate this, we’re going to look at the growth of $100,000 invested over a period of 30 years in 3 funds with different expense ratios:
- 0% fees (an imaginary investment only available in Utopia).
- 0.20% fees (what you typically pay with a portfolio of index funds or ETFs).
- 4% fees (typically charged by insurance-linked schemes and offshore saving plans).
We’re going to assume that these investments will generate an annual return of 8% (before fees). Let’s compare how your money would grow with these three funds:
Leading the pack is the Green line which represents the utopic investment that charges no fees. All the money invested is fully working for you. Therefore, $100,000 invested in this fund would be worth $1,006,266 after 30 years. That’s awesome, but alas… Only Santa Claus and the Tooth Fairy can actually invest in this fund!
A close second is the Blue line which represents the low-cost index fund or ETF. With only 0.20% in fees, if you invested $100,000 in this fund, your portfolio would have grown to $951,837. That’s not far behind the ideal no-fee fund.
Now let’s look at that distant third Red line representing an offshore saving plan or an insurance-linked scheme. With a whopping 4% in fees, your money would only be worth a meager $324,339 after 30 years. That’s a gap of $681,925 with our zero-cost reference fund! Nearly two-thirds of your retirement portfolio has evaporated in fees over the years! Where did all that money go? “Thank you for your business”, I hear the financial industry saying…
Remember that phone you bought for 20x more in the previous example above? You’re going to find out that not only it is ridiculously expensive, but it’s also much slower than your friend’s cheaper phone…
2. Professional Money Managers Consistently Fail to Beat the Index
When you hand your money over to professional fund managers, you would expect them to do a good job. After all, the typical fund manager is leading a group of financial analysts, economists, and professional traders. They have their finger on the pulse of the economy and a flair for opportunities or future market trends. They are seemingly best suited to pick the best stocks for their fund to maximize your returns and beat the market. Or, are they?
Actually, the facts suggest otherwise. The S&P Indices Versus Active (SPIVA®) regularly measures the performance of actively managed funds against their relevant index benchmarks worldwide. SPIVA® scorecards are published semi-annually for several markets such as the United States, Canada, Europe, and Australia among others.
The SPIVA® reports have shown time and again that the vast majority of actively managed funds fail to match (let alone beat) their benchmark index for any given time period. In fact, the more you stretch the timeframe, the more actively managed funds will underperform their benchmark.
Let’s take for example the most famous benchmark, the S&P 500 (Standard & Poor’s 500). This is an index that represents a basket of 500 of the largest publicly traded companies in the US. These include household names such as Apple, Amazon, Tesla, Johnson & Johnson, Coca Cola, etc…). The below chart shows the percentage of actively managed large-cap funds that have underperformed the S&P 500 index over multiple time frames as per the 2021 mid-year SPIVA® scorecard.
Over a single year, more than half (58%) of the actively managed funds have underperformed the S&P 500. It gets worse as you stretch the timeframe: over a period of 20 years, 94% of active funds have failed to match the performance of their index!
But what about the remaining 6%? There seems to be a minority of funds that still managed to beat the index over a period of 20 years. So, why don’t we just invest in those? Well, not so fast! SPIVA® Persistence Scorecards are another set of regular publications that measure the consistency of a fund’s performance over time. These reports show that the outperformance of the few actively managed funds is pretty much short-lived. This means that the majority of funds that have been yesterday’s winners will most certainly be tomorrow’s losers…
This phenomenon is known as the “reversion to the mean”, a fancy way to say that high-flyers will ultimately revert back to mediocrity. This means that chasing past performance outliers is pretty much like trying to win the lottery using last week’s winning numbers. Therefore, when a financial advisor tries to tempt you with the past stellar performance of his firm’ funds, smile, thank him/her politely and walk away. In all cases, it is wiser to choose a low-cost index fund over a more expensive actively managed fund regardless of their past performance.
3. The Vast Majority of Financial Advisors are Salesmen in Disguise
Wolves in Sheep’s Clothing
No matter how fancy their title might sound (financial planner, wealth manager, financial architect, etc…), the vast majority of financial advisors are sales brokers in disguise. They receive large commissions for selling long-term saving plans, whole-life insurance, and other financial products that are very lucrative (for them). Some of these products pay the broker an upfront commission equivalent to 18 months worth of your contributions! Did you ever wonder why you don’t get anything back if you cancel the plan in the first two years? That’s right: it’s because the money is already gone!
This is not to demonize the brokers out there or to say that all financial advisors are evil. They are just selling whatever they’ve been trained to sell. Even the best-intentioned advisors are working in the confines of a system that is rigged against the investor. Remember: these brokers are working for the “house” and as the saying goes, “the house always wins”.
Advisors With a Conscience
On the other side of the spectrum, there is that rare breed of fee-only advisors that are “fiduciaries”. This means they are held by high ethical standards and put their client’s best interest front and center. These advisors do not try to sell you anything, nor do they receive any kick-backs for putting you in some dodgy investment plans. They earn their living by charging a flat fee for their financial advice. They typically help you build a portfolio of low-cost index funds. These fiduciaries are quite hard to find even in some of the most developed countries (i.e. US, UK, etc…). They’re even much harder to find in developing countries. For example, in the Middle East, you could probably count them on a single hand with a few fingers to spare.
Conflicts of Interest
The financial industry is inherently flawed with some undeniable conflicts of interest. In fact, the interests of the investor are oftentimes the polar opposites of those of the financial industry and its sales brokers as you can see in the below table:
| Investor | Financial Industry (investment banks, insurance companies and sales brokers) |
|---|---|
| Having the full invested amount working for the investor | Take a percentage of the invested money in upfront sales commissions to maximize company profits |
| Minimizing ongoing fees to maximize investment returns | Maximizing ongoing fees and other charges to maximize company profits |
| Compounding the invested money for maximum growth | Compounding the plan fees for maximum company profits |
| Ability to withdraw the invested money in full, at any time, without any penalties | Applying high surrender penalties to lock the investors in for as long as possible to maximize company profits |
Remember: the financial firms exist first and foremost to make money for themselves, their shareholders, and the brokers who sell their products. Retail investors like you and I are way down on their food chain.
4. Economists, Investment Managers, and the Media Get It Wrong All the Time
The financial industry sells the delusion that, if you are “smart enough” and if you follow the economy and the financial news, you could gain a competitive edge in the market. Armed with these predictions, you might believe that you could either benefit from the market rises and/or avoid the falls. Nothing could be further from the truth! Unless you are wise to this trap, it is easy to fall for it.
Economists, analysts from big-name investment banks and financial reporters repeatedly make predictions about the market. They project where the S&P 500 will be at the end of the year, or where interest rates or inflation are heading. They also set future target prices for individual stocks and proclaim which sectors or regions are hot and which are not. Some of these “experts” actually believe their own predictions, while some others are just salesmen.
Sure, every once in a while, someone will eventually get it right. When that happens, he/she is proclaimed a “seer” and will gather more media coverage. But then again, even a man with a broken watch can tell you the correct time twice a day.
Merchants of Doom
Nouriel Roubini is an economist that became famous after he predicted the housing bubble crash of 2007–2008. His predictions have earned him the nickname of “Dr. Doom”. What people don’t know, though, is that he predicted a recession in 2004 (incorrectly), in 2005 (incorrectly), in 2006 (again, incorrectly) and in 2007 (sorry, not yet…) until he ultimately got it right in 2008.
To add insult to injury, he also advised people to stay out of the stock market in April 2009 right when the market started its amazing recovery at the dawn of the longest bull market in history! In 2010, he warned that the crisis was not over yet (sorry, Dr. Doom!). In 2012, he predicted an economic turmoil for 2013 (it didn’t happen). Would you imagine how bad your investments would have performed if you had listened to Roubini’s predictions?
I’m definitely not picking up on Dr. Roubini. He has a Ph.D. in International Economics from Harvard, so I’m sure his IQ runs circles around mine. What I’m trying to say is that even smart and knowledgeable people are unable to make accurate predictions about the financial markets.
Hall of Shame
Here’s my compilation of failed predictions made by market prognosticators including economists, investment managers and other analysts:
- “It’s Coming: One Pro Sees Big Stock Selloff in 10 Days”, CNBC, Sep 4, 2012.
- “Signs of a Market Correction Ahead”, Barron’s, August 13, 2013.
- “Time to Brace for a 20% Correction”, Barron’s, December 14, 2013.
- “Two experts warn correction could total 60%”, CNBC, Aug 24, 2014.
- “The stock market is long overdue for a big drop”, CNN Business, June 4, 2015.
- “Brexit would prompt stock market and house price crash, says IMF”, The Guardian, May 13, 2016.
- “Mark Cuban warns of stock-market disaster if Trump becomes president”, MarketWatch, May 17, 2016.
- “Hedge-fund manager warns of biggest market correction since 2008”, MarketWatch, Sep 23, 2016.
- “As Black Monday Turns 30, Is an Even Worse Stock Market Crash on Its Way?”, NBC News, Oct 19, 2017.
- “Rich Dad Poor Dad author Robert Kiyosaki warns ‘biggest crash’ is coming”, news.com.au, Aug 6, 2018.
- “JP Morgan’s top quant warns next crisis to have flash crashes and social unrest not seen in 50 years”, CNBC, Sep 4, 2018.
- “The Fed Can’t Prevent a Market Meltdown, Warns an Analyst Who Called the 2008 Housing Market Collapse”, MarketWatch, July 24, 2019.
- “‘Last Chance to Sell’: Hedge Fund Warns of Impending Stock Market Crash”, CCN, May 3, 2020.
- “‘The dollar is going to fall very, very sharply,’ warns prominent Yale economist”, MarketWatch, Jun 23, 2020.
- “IMF warns of ‘sharp adjustment’ in financial markets despite ‘remarkable’ recovery this year”, CNBC, Oct 13, 2020.
- “Carl Icahn warns that the market rally could end in a painful correction and is hedging accordingly”, CNBC, Jan 4 2021.
- “Market bull Tom Lee predicts a record September, but warns that a 10% correction could come in October”, CNBC, Sep 6, 2021
- “Stocks could be due for a correction of up to 20% ‘by fire or ice’: Morgan Stanley strategist”, Yahoo! Finance, Sep 10, 2021.
There are two things in common for all the above predictions. They have catchy titles for magazine cover stories or news headlines, and they all turned out to be totally wrong!
5. Active Trading and Market Timing Are Hazardous To Your Wealth
Active Trading
Buying and selling individual stocks (sometimes on the same day) might seem smart on the surface. Active traders make a profit by buying what is believed will go up and selling what is believed will drop in price. The problem is that no one can really predict, with any degree of accuracy, how individual stocks, bonds, sectors or funds will behave in the short term.
Despite that, there is no shortage of resources on the internet that make it look easy. Many are actually flaunting their stock trading “secrets”. They promise to teach you how to analyze and trade stocks to make “easy profits” (for a fee of course).
But again, academic evidence shows that active trading loses to indexing (i.e. buying and holding index funds). In the 2000 paper “Trading Is Hazardous to Your Wealth” published in the Journal of Finance, researchers have analyzed the performance of more than 66,000 traders. They have found that between 1991 and 1996, while the market returned 17.9%, the average traders made 16.4%. The most active traders, however, only made 11.4%, underperforming the market by 6.4%! The paper concluded, just as its title says, that that trading is hazardous to your wealth.
This wasn’t surprising. We’ve also seen earlier that the best money managers that actively trade stocks consistently fail to beat the broad market (or the index) over time. These professionals have a team of full-time analysts. They also have instant access to information not readily or easily available to the retail investors. If these full-time professionals with their arsenal of resources cannot consistently beat the index over time, what are the chances for someone like you or me? Do you think we know something that these guys don’t?
Market Timing
Market timing refers to the act of attempting to predict the future direction of the market, typically through the use of indicators or economic data, and then trading assets (i.e. either buying or selling) based on that information at the appropriate time. This is another mirage. We’ve seen above that economists and other market forecasters cannot accurately predict short-term market movements, let alone the time of those changes.
To be able to time the market profitably, one would need to know when to get in (i.e. buy), but also when to get out (sell). Academic research has shown time and again that it is nearly impossible to do so consistently over an investment lifetime. The odds are heavily stacked against you.
In brief, active trading and market timing are hazardous to your wealth. Although they are considered to be a fool’s errand, a lot of people would not stop trying. Why? Because the financial industry makes that all look compelling, but mostly because hope springs eternal…
6. There’s a Cheaper & Better Way to Invest
If picking individual company stocks and timing the market does not seem to work, and if by handing your money over to professionals (i.e. bankers, insurance companies, fund managers, etc…) you’re giving away two-thirds of your lifetime investment returns, what’s a viable alternative?
The answer is to invest in low-cost index funds. An Index fund is a basket of securities that represent a certain market. It typically holds the components that are included in the index they track. For example, an index fund that tracks the S&P 500 holds stocks from all 500 US companies that represent the index. Companies are represented in the fund in proportions relative to the size of each company in the index. If Apple makes up 6% of the S&P 500 given its size (also known as market cap), then 6% of the money in that fund will be allocated to Apple stocks. If Tesla represents 2% of the index, then 2% of the money goes to Tesla stocks. You got the idea.
The management of index funds is mostly automated, which explains their low cost. Rather than having an expensive manager with his team of expert analysts trying to trade back and forth in an attempt to outsmart the market, index funds simply buy and hold all the stocks in a particular index.
Index investing is backed by an overwhelming amount of empirical evidence. It was endorsed numerous times by academic researchers, Nobel laureates, and investment titans (including Warren Buffet himself). They all agree that investing in a broad-market index fund is a sure way to get your fair share of the market’s returns over time at a rock-bottom cost.
7. Investing is Simple
Let me get this straight. Investing is not nearly as complicated as the financial industry would want you to believe. If you have ever bought anything online, you already have what it takes to invest!
All you need is to open an account with an online trading platform, transfer money there, and buy a couple of low-cost Exchange Traded Funds (ETFs). After that, you just continue adding money regularly and buying the same ETFs over and over again, regardless of market conditions. You don’t need to follow any market forecasts, financial news, or the economy. That’s really all there is to it. In fact, this is such an effortless approach that some people commonly refer to it as “couch-potato investing”. The best part? It just works!
