Original Version: 2020 (with updates from 2022)
There’s one reason and one reason only why I haven’t written this post yet: It’s provocative! It gets the people going!
(Only half-kidding.)
Truthfully, I’ve been nervous about it. Although I’ve done my best to confirm that everything is factually, statistically, and mathematically true, I have friends and acquaintances that work in wealth management in some capacity. They range from analysts to fund managers, and they make their living on the exact thing I’m about to discourage you from doing.
I’ve been putting it off—I didn’t want to piss anyone off.
But in the personal finance world, this fact—that you’re likely better off investing on your own rather than paying another human being 1% of your net worth to do it for you—is not really disputed. It’s becoming accepted as the truth.
What do I mean by “on your own”?
When I say “on your own,” I don’t mean without any help at all (let’s be honest, this entire website is dedicated to the fact that we all probably want some help). After all, using a roboadvisor to manage your assets isn’t free (it’s typically around 0.25% per year, or $25 per $10,000), but it’s a lot less than the 1-2% fee that your friendly money manager named Dennis from Michigan will charge for a few hours of his time every year.
What I mean is, you shouldn’t, under almost any circ*mstances, pay another individual (financial advisor or otherwise) a seemingly low percentage of your net worth year over year to actively manage your money for you without knowing the alternatives. This is known as an assets under management model, and it can be incredibly costly—but they won’t tell you that.
2022 UPDATE: I want to clarify here that I’m talking specifically about an AUM model, and not an hourly fee-only model. Paying a professional who’s both (a) fiduciary and (b) has a CFP designation for specific help and advice can be a very good idea, as is employing other financial professionals when needed (like CPAs), especially as your net worth grows and situation becomes more complex.
What I’m suggesting is being very wary of models wherein all of your money is managed by another person for 1% (or more) each year.
While we’re about to dive head-first into the #sexymath, the fees you’d be charged are intentionally deceptive. 1% per year? Who cares, right? You get to keep 99% of your money! What could be easier than that?
That’s what they want you to think.
That 1% per year compounds just like your interest compounds, and I’ll show you in a few moments just how debilitating this fee can be.
The super-extra messed up part is that the 1% you’re paying them is in addition to the funds’ expense ratios themselves. For example, you may be paying 0.5% for the funds they’re investing you in—and then the extra 1% goes straight in their pocket.
But let’s back it up a step first.
Should I pay someone the 1% (or more) fee if they can get me better returns?
Well, sure!…if it were that easy to do.
A fund manager promising you they can just “beat the market” for you would be like me joining a crowd of rowdy high school boys for a pick-up game of basketball and telling them I’ll “just play like LeBron James.”
Think about this logically: If you’re paying them a 1% fee, that means to even break even with the market, they’d have to beat it by at least 1% every single year, consistently (because you’re paying them 1%). In order for it to be actually worth your while, they’d have to beat the market by >1% every year.
And if you’ve ever barely passed a test, you’re probably like, “How hard could that be? 1 stinking percentage point? I could probably do that!”
And you’re right—beating the market once? It’s possible. But do you know how possible? Let’s dig into statistics:
Fewer than 20% of actively managed funds beat the market over a 1-year timeframe.
That means 80% of the time, passive investing (buying an index fund and holding it) wins when examined over a full year.
But what about over 5 years?
Fewer than 10% of actively managed funds beat the market over a 5-year timeframe.
And if you’re a long-term investor like I am, you’re probably curious what the long game is: Okay, Katie, sure, but what if I want to stick with this person for life? A long-term relationship? What about then?
Glad you asked!
Fewer than 1% of actively managed funds beat the market over a given 30-year timeframe.
(Source: ChooseFI episode 284, “JL Collins Returns.” You can check out the episode and summary notes here. JL also talks about these statistics in his book, The Simple Path to Wealth, which I reviewed here.)
Let’s pretend you’re gambling here: Would you like to go with the method that works 99% of the time, or the one that works 1% of the time?
I’m not a betting woman, but I know which one I’d choose.
“Passive management” of your money essentially means that you’re buying (and holding) low-cost, diversified assets and—instead of trying to beat the market—you’re just trying to keep up with it.
Let’s talk about incentives
If this method seems so ineffective, why do people pay for it?
Well, they’re clearly not Money with Katie readers (winks) but it’s mostly because these wealth management companies have good marketing. They’ll sell you on some strategy they have (some “proprietary methodology” of picking funds, that, of course, they can’t actually tell you about) and why it’s worth the extra fees. Maybe they’ll offer extra services. Regardless, you’re paying through the nose for it.
And you know what? You probably won’t notice you’re paying through the nose for it, because the fees are charged in an incredibly subtle way. Little by little, you’ll be charged management fees on your statements. $50 here, $100 there—you don’t just receive a bill at the end of the year for $5,000. (Because if you did, they know you’d take a step back and say, Wait a second, $5,000? I’ve talked to my money guy twice this year for about an hour each time. I did not get $5,000 worth of value out of this.)
And why does it work for them? They may tell you that their incentives are aligned to yours: When you make money, I make money! Well, that’s true—they are making money off your money—but that statement is misleading. Even when you LOSE money, they still make money, because they’re getting 1% of the total balance of your portfolio every. single. year., regardless of whether or not they beat (or even keep up with) the market. It goes up or it goes down, they collect their 1%.
So while their incentives are slightly aligned to yours, their disincentives are not.
And you know what? It wouldn’t even matter if they were aligned—because even the best fund manager in the world with the best of intentions could want more than anything to beat the market for you, and still fail. That’s how hard it is. You saw the numbers: Even in just a 1-year window, fewer than 20% of funds do it.
Everyone loves to point to examples like Tesla. I can’t tell you how many times I’ve heard, “Well, I bought Tesla at $100 and I’ve made 39487239872% on it!” That’s wonderful, and I’m genuinely happy the lucky stock pick worked, because it’s rare—and anytime it works is exciting.
If you can consistently do that every single year for the rest of your life, then you’re going to be a very rich person before long. But one bad pick? One pick that goes from $100 to $0? You wipe out all that positive momentum. Picking stocks is like gambling. Paying someone else to pick stocks for you is paying someone else to gamble your money.
Index-based ETFs can’t go to $0, because they’re composed of hundreds (if not thousands) of companies.
What’s the effect of these fees over time?
While the actual outcomes can vary depending on (a) how much you’re investing and (b) over how much time (here’s a NerdWallet article that illustrates how a 1% fee can cost Millennials with a long retirement horizon nearly $600,000 over their lifetimes), a good way to think about it is this:
You know how I love early retirement math? That you can withdraw 4% of your total portfolio value year over year and never run out of money after you invest 25x your annual expenses? (See, I told you this math was sexy.)
Think about that. If you save $1,000,000, you can withdraw $40,000 per year to live on, and compound interest will replenish your portfolio value (and then some, usually) by the time you go to withdraw again.
How does a 1% fee impact that?
Well… 1% of your annual 4% withdrawal has to go to the guy who’s spending about an hour a month glancing over your sh*t.
Does that feel fair to you?
No matter how little or much effort that person is exerting on your behalf—even if they are well-intentioned, altruistic, and talented, as many are – the likelihood that that individual is going to be able to justify their own 1% value to you over a 30-year timeframe? We already know. It’s less than 1%.
If I’m spending $10,000 per year for someone to manage my $1M portfolio, that actually means I could run out of money if I needed $40,000 per year to live. That’s the difference 1% can make.
In order to generate $10,000 of interest income per year to pay your fund manager, you’d need to have an additional $250,000 invested (25x your $10,000 annual expense).
That means you no longer get to retire at $1M saved—you need $1.25M. And guess what? Now your fee goes up, because 1% of $1.25M is $12,500. Which means you need an extra $312,500, not $250,000 saved. Which means it goes up to $1.31M. Which means…
See where I’m going with this? See why that pesky little 1% becomes unsustainably problematic for your early retirement dreams?
2022 Update: The behavioral value-add
Because more and more retail investors are becoming familiar with the way fees compound and the infrequency with which professionals (even hedge fund managers, the supposed creme of the crop) beat the market, many financial professionals position their true value-add as behavioral. As in: They create a barrier between you and your money to help prevent you from panic-selling during a bear market.
While I think this argument is valid (and a more accurate representation of their value add), I would note that it’s—by definition—completely in your control whether or not you have the behavioral chops to ride the waves of a bear market. If you’re reading this article, my guess is you’re attempting to make a good faith effort at learning enough to do just that.
Paying someone else 1% per year to manage your emotions for you (among other things) is expensive, in my mind, but its true value is subjective if you’re afraid you’ll panic-slap the sell button.
If you’re like, But Katie, I need #help
Welcome to my purpose in life—and the purpose of this site.
Because I know some people don’t feel comfortable investing tens of thousands of dollars on their own, I think roboadvisor solutions (which charge a fraction of what an active fund manager would demand of you) are the perfect middle ground. I’ve recommended it to people for years since I found it in 2018 because you literally don’t need to know anything about investing to use it.
Roboadvisors utilize the same “buy and hold” strategy that iconic investors like Warren Buffett (one of the greatest investors of all time) and Jack Bogle (founder of Vanguard and inventor of the index fund) advise, but they can ensure proper diversification on your behalf, harvest losses for tax benefits, and coordinate your asset allocation properly across tax-advantaged and taxable accounts to minimize your liability.
That’s a fancy way of saying they’ll do all of the actually valuable things a financial advisor would do for you, without the whole “foolishly trying to beat the market, triggering a bunch of taxable events, and charging you handsomely to do it” part.
One of the primary reasons I always suggest robos for people who are gun-shy about investing is that their website and app are incredibly user-friendly. You don’t get the sense that you’re going to press the wrong button and blow up the Pentagon, which is how I feel half the time I use traditional brokerage firm websites.
And of course, if you do feel comfortable operating directly on Vanguard.com, you can buy diversified index funds with extremely low expense ratios there directly and remove the middleman entirely.
Fees
You’re probably wondering how I’m cool with a 0.25% fee when I just railed against a 1% fee (although in investing, that’s a significant difference).
Here’s why I’m okay with the ~0.25% fee: The level of diversification, control, and tax advantages justify it to me. I don’t have the patience or time to enact tax loss harvesting (tax loss harvesting is where you basically sell an asset that’s down to “realize the loss” for tax purposes, and then immediately buy a similar asset to hop back in the market and participate in the rally, but you have to be careful not to violate the wash sale rule).
Moreover, when you decide you want to rebalance, you just change your breakdown and most robos will execute the trades in the most tax-efficient way.
You literally slide a glider further to the left or right of a “stocks vs. bonds” spectrum to set your risk tolerance, and the portfolio will be optimized by an algorithm in an appropriate way without making tax-heavy mistakes (that frankly, I don’t trust regular people not to make—I pride myself on knowing what I’m doing, but taxes on that micro level can be tricky).
I like how they’ll show you a warning message when you do something that, even after they strategize on your behalf about how to execute the trade, it still may result in a tax bill of $X. You’re able to determine before moving forward whether or not you’re comfortable with that, rather than plowing blindly forward and hoping for the best, with no surprises.
This isn’t meant to be a trash talk session on actively managed fund advisors
It’s only intended to show you what you’re likely really paying for—a slim chance at beating the market, with a big, big long-term price tag.
Every single time I go home, I try to convince my parents to break up with their financial advisor, but they’re in too deep. I think they’re afraid to calculate how much they’ve paid him over the last three decades, but trust me, he’s probably got a vacation home on my parents’ dime in exchange for their biannual phone calls. Good for him. I can’t deny the guy’s a hustler.
Ultimately, I know I’ll probably receive some heat for this one, but I cannot—in good blogger faith—ignore this topic just because there are financial advisors in my audience.
And you know what? If you consider all of this and still decide it’s worth it to you, that’s your prerogative and I’ll just be happy you’re making the decision knowing all the facts.
But trust me when I tell you: You are competent enough to take the simple path. If I thought there were a complicated path I could take that would produce better returns but cost a little more time or money, believe me, I’d be doing it. #YearnToEarn, remember? I love money and #gainz, so I’d put the legwork (or investment) into a better way if there were one. If the data told me that actively managed funds and fund managers were worth it, I’d pay their fee.
Low-cost, diversified index funds that are tax-optimized is going to be your best possible chance at becoming a 35-year-old millionaire in 99.9 of 100 scenarios, unless you create an app and get acquired by Google. Then, do that instead.
