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Factors That Reduce Returns On Investments – Get More Bang For Your Buck

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Introduction

 

 

Investing, as you can already tell, can involve a lot of capital that is essentially tied in various financial assets. The goal as it is for everyone is basically the same: They want to make more money – everyone does after all. But, there may be tiny, minuscule details that investors tend to underestimate or are unaware of – and in this lesson, we will be explaining the factors that reduce the returns on investments – as this can cripple your profit potentials and defer your long-term investing goals.

 

But before we begin, we would like you to read and agree to the Terms & Conditions of this post before you proceed any further.

Disclaimer: Invest In Wall Street is in no way financially or legally responsible for any investing decisions made by any of our readers and are, in turn, acting on their own free will. The information in this article is purely educational and should not be abused or misconstrued in any way, shape, or form.

 

 

Barriers To Long-Term Growth

 

A common misconception is that long-term growth is only achieved by picking stocks or mutual funds that deliver big returns. The challenge of finding the next explosive hot stock or winning mutual fund manager appeals to some investors.

But experienced investors understand that achieving long-term growth may have less to do with chasing hot trends in the hopes of hitting it big, and more to do with minimizing barriers to long-term growth.

Some barriers to long-term growth include commissions that cut into your investment principle, fees that chip away at account balances, and, of course, taxes.

 

 

Commissions are the cost of buying and selling securities such as stocks, bonds, mutual funds, and exchange-traded funds, or ETFs. The higher the commissions, the higher the returns need to be to offset the purchasing cost.

Although commissions have declined over the past decade, they can still add up, particularly for active investors.

Investors who want to attempt to minimize transaction costs can consider the following steps.

First, investors can carefully plan every investment, including entry points, exit points, and stop orders – as this process encourages disciplined investing.

Randomly placing trades can result in poor performance, and paying needless commissions.

Second, investors can take advantage of commission-free ETFs offered by brokers. Recently, many brokers have begun to offer commission free trades on selected ETFs. Some brokers even have over 100 ETFs that fall into this free-to-trade category.

Along with commissions, investors should minimize the impact fees have on returns.

Virtually every mutual fund and ETF has ongoing expenses, associated with owning the fund. These fees, called the expense ratio, are the costs associated with the maintenance, marketing, and management of the fund or ETF.

Fees vary widely across funds. At the low end, fees might be around a quarter of a percent (0.25%), or even less. At the high end, fees might be 1 and 1/2% to 2%, or more.

 

 

A fund with higher fees is usually actively managed, which means a manager picks and chooses investments.

In contrast, a fund with lower fees is typically passively managed, which means it simply tracks an index.

A passively managed fund is also known as an index fund. Though the difference in fees between index and actively managed funds might seem small, it can add up over the long run.

 

 

 

Moreover, in most cases, the extra fees associated with actively managed funds may not be worth it, because only a small number of managers beat a market benchmark like the S&P 500 over long periods of time. That’s why it might be a good idea to consider index funds, including ETFs with lower fees.

These index funds tend to outperform similar to actively managed funds because of their lower management fees.

Finally, after commission and fees, a third step investors can take is to manage taxes.

Investors may want to start taking full advantage of tax-deferred retirement accounts, such as employer sponsored plans and individual retirement accounts, or IRAs.

For investments that are not tax-deferred, investors should try to be as tax efficient as possible. For example, investors can hold positions for over a year to take advantage of lower long-term capital gain tax rates.

 

 

Minimizing taxes, fees, and commissions potentially helps a portfolio’s long-term growth. Consider the difference in growth of the following two portfolios:

One ignores the impact of commissions, fees, and taxes, while the other portfolio attempts to minimize them

Suppose for example, both portfolios start with a balance of $50,000 and grow 11% per year before commissions, fees, and taxes.

Let’s assume the first portfolio ends up paying 4% per year toward taxes, fees, and commissions, reducing the overall return to 7% per year.

After 20 years, the portfolio would grow to $193,484. That’s a decent return, but Let’s look at the long-term growth of the portfolio that minimized commissions, fees, and taxes.

Suppose these costs totaled 2% per year in a tax-deferred portfolio. After 20 years, with 9% growth, the portfolio would grow to $280,221.

That’s almost $100,000 more than the portfolio that ignored costs.

To clarify any confusion as to how I received these calculations – you would have to use the compound interest formula – as this is how most investors predict the theoretical value of their investment over a set time period.

 

 

The first portfolio has a principal (P) of $50k, a rate of return (r) of 7% after taxes, commissions, and fees, compounded annually (n=1), and you want to find the growth of the account after 20 years (t). Simply plug it into the formula and this will give you the theoretical value of your portfolio – approximately $193,484.

The tax-deferred portfolio, on the other hand, has a rate of return (r) of 9% after taxes, commissions, and fees – which is far greater than that of the first portfolio. Using the previous data as constant variables, you will receive a theoretical value of $280,221 – allowing you to achieve a greater return.

As you can see, managing barriers to long-growth, like commissions, fees, and taxes, can potentially help improve the long-term growth of your portfolio.

Although the difference between a few extra commissions, a 1% management fee, and taxes, might not seem like a lot today, but over the course of 20 years or longer, it could mean the difference between reaching a financial goal or not.

 

 

Quick Recap

In Review……

 

Factors That Can Reduce Your Returns

 

1. Commissions

  • The cost of buying and selling securities such as stocks, bonds, mutual funds, and exchange-traded funds, or ETFs. The higher the commissions, the higher the returns need to be to offset the purchasing cost
  • Although commissions have declined over the past decade, they can still add up, particularly for active investors
  • Randomly placing trades can result in poor performance, and paying needless commissions

2. Management Fees

  • Virtually every mutual fund and ETF has ongoing expenses, associated with owning the fund. These fees, called the expense ratio, are the costs associated with the maintenance, marketing, and management of the fund or ETF
  • Fees vary widely across funds. At the low end, fees might be around a quarter of a percent (0.25%), or even less. At the high end, fees might be 1 and 1/2% to 2%, or more
  • A fund with higher fees is usually actively managed, which means a manager picks and chooses investments
  • In contrast, a fund with lower fees is typically passively managed, which means it simply tracks an index
  • A passively managed fund is also known as an index fund. Though the difference in fees between index and actively managed funds might seem small, it can add up over the long run
  • Moreover, in most cases, the extra fees associated with actively managed funds may not be worth it, because only a small number of managers beat a market benchmark like the S&P 500 over long periods of time

3. Taxes

  • Minimizing taxes, fees, and commissions potentially helps a portfolio’s long-term growth

 

 

Valuable Tips & Loopholes

  • Investors can carefully plan every investment, including entry points, exit points, and stop orders – as this process encourages disciplined investing
  • Investors can take advantage of commission-free ETFs offered by brokers. Recently, many brokers have begun to offer commission free trades on selected ETFs. Some brokers even have over 100 ETFs that fall into this free-to-trade category
  • It might be a good idea to consider index funds, including ETFs with lower fees. These index funds tend to outperform similar to actively managed funds because of their lower management fees
  • Investors may want to start taking full advantage of tax-deferred retirement accounts, such as employer sponsored plans and individual retirement accounts, or IRAs
  • For investments that are not tax-deferred, investors should try to be as tax efficient as possible. For example, investors can hold positions for over a year to take advantage of lower long-term capital gain tax rates

 

And these are the financial penalties that you tend to encounter when investing in the stock market – that being commissions, fees, and taxes. One thing that I want to point out is that commissions and taxes is applicable to all asset classes – while management fees are only applicable to mutual funds and ETFs.

Though, I must say, that these could be the silent killers of your portfolio – and they can exponentially reduce your gross profits.

I hope you have enjoyed this post and found the information to be quite useful. If you have any questions or concerns, please feel free to leave them down in the comment thread below and make sure to like and share this post.

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