DIY Investing Keeps Costs Low
How much of an income stream can you expect from a well-balanced portfolio of investments? The industry consensus is 3-4% 3% if you.re young. 4% if you.re in your retirement years (65+). This was discussed in Passive Income Part One. The rationale is that the younger you are, the less you can draw down because you need the portfolio to weather down years. In my life, there seems to have been a stock market disaster every decade (1987 Black Monday, 1999 tech bubble, and 2008 Great Recession). It.s easier for the portfolio to bounce back from down years if it has more capital inside it. Everyone.s always worried about stock market disasters. But believe it or not to do absolutely nothing is the best course of action. More on this later. What I want to cover today is how important it is to keep costs low. The best way to keep costs low is to be a DIY investor.
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Expenses Incurred in Non-Stock Investments
To give you an example of how important it is to keep costs low with stock market type investments, here are two examples of expenses from non-stock market investments. There.s all sort of examples I could have used, but since in Passive Income Part One I used an analogy comparing capital gains to the appreciation in the value of a house and dividends to the rental income stream, I.m going to used real estate examples.
Let.s say you own a piece of commercial real estate. It could be an office building, a restaurant, or a retail space. If you want a management company to find tenants for you, they will charge you based on the rent. Typically 3-5% of the yearly rent. So if your piece of commercial real estate generates $100,000 a year, you will pay them between $3000 – $5000 a year. Every year. It.s not just the first year the tenant signs the lease!
Okay. So with this piece of commercial real estate, you pocket $95,000 and the management company pockets $5000.
Let.s go on to the second example. Say you own some investment real estate. It doesn.t matter whether it.s a condo or a house. If you want a management company to find tenants for you, they will charge you based on rent. Typically 10% of the yearly rent. So if your house generates you $20,000 a year, you will pay them $2000 a year. Every year. It.s not just the first year they sign up the tenant.
You can see how this is really a good deal for management companies. If a management company succeeds in managing 10 residential properties, they make as much income as an owner who owns one house! The management company has put down zero capital and incurs none of the risks associated with the property (it burns down, depreciates, tenants don.t pay, and so on). On the other hand, the owner has to come up with the capital to buy the house and takes on all the risks of owning property!
Of all the real estate investors I know, they all manage their properties themselves. They keep costs low. Now, let.s return back to stock based investing.
What are the costs of investing in mutual funds or hiring a fee based advisor? A 2013 study found that the average MER (management expense ratio) of mutual funds in Canada is 2.42%:
Costs of Owning a Mutual Fund 2013
So with a $10,000 portfolio, it costs the investor $242 each year. For a $10,000 portfolio, fee based advisors charge 1% of AUM (assets under management, the scale slides down with larger portfolios). That works out to be $100 each year. At this point, most people (but not the diligent readers of this blog) would say, ‘That.s not a bad deal compared with the real estate examples where the management fees were 10% (residential) and 5% (commercial)’. There.s always a but. And here it is. But in the real estate examples, the fee came off as a percentage of the revenue or the rental stream, not the market value of the real estate holding itself. In the stock example, the fee comes off the total value of the portfolio. This makes a huge difference!
Put it this way. Do you recall the amount you can draw down from a well-balanced portfolio of stocks and bonds each year. It.s 3-4%. Let.s say you.re a young investor. You can draw down (spend) 3% each year. On a $10,000 portfolio, that.s $300 a year. If you.ve invested in mutual funds, $242 of that will go into paying management fees, leaving you $58 to spend. If you.ve invested with a fee-based advisor, $100 of that will go into paying management fees, leaving you $200 to spend.
In the residential real estate example, things look good for the management company because they only have to manage 10 houses to enjoy the same income as an owner of one house. And, in managing 10 houses, neither did they have to come up with the hard earned money to buy them nor are they exposed to any of the risks of owning houses (fire, flood, earthquake, etc.,). In the mutual fund example, the management company makes more money than the investor right off the bat ($242 vs. $58). In the fee-based advisor example, the management company enjoys the same income as an investor with a $10,000 portfolio once it manages 3 investors with $10,000 portfolios. The moral of the story is costs are critical!
DIY is the Answer
DIY is the way to control costs. It.s the same with anything. Take dining out. Dinner and a few drinks comes to $50. If I DIY, I can feed myself for a whole week for the price of one meal out.
The financial industry is a huge behemoth. Every year you hear banks have record earnings. Well, after the analysis, you can see how they.re able to enjoy record earnings each year. To me, the financial advisors at banks are first and foremost salespeople. In 2007, I offered to help my folks manage their investments. Originally, dad wanted to go stay with the financial advisors at his bank. He said how much return could he expect if I managed them. I said he could expect to spend about 4% each year and that this amount would be inflation adjusted (i.e. it would keep track of inflation). He said the bank was telling him they charged nothing for their advice and that he could draw down safely 7-10% each year. I told him that, well, that.s not possible. His response was that the bank people are experts and I was not. Well, actually what happened is that mom was getting tired of dealing with the bank people and the stress of investing was getting to her. I.m not sure, but I think it was her call to let me manage things.
At this time, a lot of my aunts and uncles trusted their money to the banks. They were spending 7-10% a year, and, on top of that, the banks were giving them free vacations each year for investing with them. If it.s too good to be true, it is too good to be true. Flash forward to 2015. My parents’ portfolios have grown. My aunts and uncles’ portfolios have been decimated. They were paying way too high fees at the banks and drawing down too much. By the time they noticed, it was too late. To me, that.s the funniest thing: you work so hard for your money and then hand it over for someone to manage without blinking an eye.
In my portfolio and my folks’ portfolios, I.ve kept costs down to not 1% and not even 0.5% but less than one-half of half a percent (~0.2%)! In the next blogs, I.ll let the cat out of the bag as to how this is possible. But to recap: in Passive Income Part One, I discussed why it.s important to invest and the things investing can and cannot do. In today.s blog, I discussed the importance of keeping an eye on costs. In Part Three, I.ll talk about how easy portfolio construction actually is.
Until next time, I.m Edwin Wong and I should be doing more of Melpomene’s work but talking about investing is too damned fun!
Bonus Quotes in Support of DIY:
‘Wall Street is the only place that people ride to in a Rolls Royce to get advice from those who take the subway’. Warren Buffett commenting on the incongruity of taking advice from people who are less clever than you are just because they are the ‘experts’.
And here.s one by Fred Schwed Jr. asking the hard question on how much value brokers give to their clients:
Once in the dear dead days beyond recall, an out-of-town visitor was being shown the wonders of the New York financial district. When the party arrived at the Battery, one of his guides indicated some handsome ships riding at anchor. He said, ‘Look, those are the bankers’ and brokers’ yachts’. ‘Where are the customers’ yachts?’ asked the naive visitor.