This is the sixth step in our complete series of Getting Started Investing. If you’re a beginner who’s looking to make your first investment and build wealth for the future, then read on.
Investing is awesome! Compounding interest plus time can turn even small deposits into large sums of money for you — that’s really awesome. What not so awesome are the fees. Let’s talk about the different types of investment fees and why you should care.
Types of Investment Fees
Commissions — a flat amount per trade or a flat amount plus percentage per trade. This amount will vary depending on your broker and the funds you invest in.
Mutual fund loads — either front-end, back-end, or a combination of both. These can sometimes be waived if the funds are held in brokerage accounts with the same broker.
12b-1 fees — internally charged fee on mutual funds. This will reduce the value of your fund by up to 1% and will be deducted automatically every year.
Management or advisor fees — a fee paid to an advisor who manages your accounts. This could add up to thousands of dollars per year, all avoidable if you manage your own account instead.
Why You Should Care About Fees
Declining markets. Sure, you don’t mind paying fees when the market is good. But do you really want to shell out fees while your account balance is decreasing? No! When reviewing different brokerage fees, ask yourself if these fees are equally acceptable in both a rising and declining market.
The cost of fees over the long-term. While some of these investment fees seem low, consider the impact over the long-term. A 1% difference in fees over 30 years could mean a six-figure loss! You are investing for the long-term, remember that when you are comparing fees.
Wow! Fees ARE really important! How can you reduce fees on your accounts?
- Look for accounts without annual fees or with waivable annual fees.
- Use a broker that charges the LOWEST transaction fees.
- Mutual fund investors should look for no-load funds or consider ETFs for lower fees.
- PAY ATTENTION to things like 12b-1 fees. They are assessed each year, make sure they aren’t too high!
- Avoid using a fund manager. Educate yourself and manage your own accounts.
For more information on investment fee types and why they matter, check out Investment Fees Matter.
Do you know where else fees can eat away at your investments? In your precious 401(k)! Yep, your company sponsored 401(k) is loaded with hidden fees!
High mutual fund expenses. In a typical employer sponsored 401(k), the funds you can invest in will be limited. Your plan may include mutual funds with high expense ratios or even sales loads that eat away at your earnings.
Recordkeeping fees. Some plans charge these fees ON TOP of the mutual fund expenses. Recordkeeping fees may be a flat fee or a percentage of assets.
Advisory service fees. Your employer may hire a 401(k) consultant and pass his or her fee on to you.
Transaction costs. Sometimes transaction costs are paid out of fund assets, reducing your potential returns.
To read more about 401(k) fees and other issues with 401(k)s, read Hidden 401(k) Expenses.
How to Calculate Your Portfolio’s Fees For FREE!
An easy way to see the total amount of fees you’re paying within your investments, is to use the Personal Capital’s Investment Checkup tool.
It’s a simple three-step process:
1. Sign up for Personal Capital
2. Add your retirement accounts to Personal Capital to sync up
3. Answer questions to determine your risk profile
Based on how you answer the questions, and your existing investments, Personal Capital will analyze your portfolio and list out the fund’s fees and other expenses. It will also show you the exact allocation of your current investments.
Personal Capital’s Investment Checkup tool is a great free tool to check whether or not you are on track for retirement.
How to Choose the Right Broker
You are ready to invest but you aren’t sure where to go? Picking out a good online discount broker is an art form. Before you make any decisions, ask yourself these questions:
- Does the broker’s ideals match my investment strategy?
- What are the broker’s trading fees?
- Does the brokerage offer banking services?
- Do they offer investment advisory services?
- Does the broker offer any research tools?
- What can I invest in with this broker?
- What type of customer service options do they have?
For a breakdown of these questions, check out 7 Things to Look For in an Online Broker.
It can be difficult to choose your broker. For a comparison of some of the highest-rated options, check out best online broker list.
What Are Margin Loans?
Have you ever heard of a margin loan? It’s a loan from broker to investor secured by the investor’s securities. A margin loan is essentially a revolving credit line secured by your investment securities that is paid back either on your timetable or when you sell the securities.
Why would you do that? Leverage. If you have $50,000 in your investment account and the market doubles over 5 years, you now have $100,000. Not bad, right? Well if you used the margin loan to buy $100,000, that same five years will get you to $200,000! That’s REALLY not bad!
As with everything else, there is a catch. If the equity in your account were to drop by 30% or more, your broker will issue a margin call requiring you to deliver more securities or pay in cash. Due to this, conservative investors generally avoid margin loans and investors typically borrow well below the loan maximum (50% of the value of securities).
Margin loans are high risk, high reward. Read more about margin loans at What is a Margin Call.
ETFs (exchange traded funds) are a great investment option! They are easy to trade, low cost, and offer a variety of assets to invest. Even better, you can find commission-free ETFs at many discount brokers including Charles Schwab, Fidelity, and Vanguard.
For more information of commission-free ETFs and the brokers that offer them, read Commission Free ETFs.
Different Types of Mutual Funds
Mutual funds come in several different classes and each class has its own fees and expenses. The most common mutual fund classes are A, B, and C for individual investors and classes I and R for institutional investors.
Class A Mutual Funds — usually charge a front-end sales load along with a small annual 12b-1 fee. Class A will require a larger investment than Class B or C. The larger your investment, the lower your upfront load fee will be. Class A funds are best for long-term investing.
Class B Mutual Funds — charge a back-end sales load and a 12b-1 fee higher than that of a Class A fund. Loads typically start high and decrease over time, completely disappearing after six years. Class B funds are best for long-term investing.
Class C Mutual Funds — may or may not charge a front-end sales load but usually charge a back-end sales load, typically around 1%. The back-end load will disappear completely after 1 or 2 years. These funds may or may not also charge 12b-1 fees. Class C funds are best for short-term trading.
Class D Mutual Funds — usually no-load funds without commissions, however, ongoing expenses are assessed. These expenses can vary, so investors should be aware of the operating expense ratios. Class D funds are purchased from brokerage firms, who will collect a 12b-1 fee.
Class I & Class R Mutual Funds — As I mentioned before, Class I and Class R are set up primarily for institutional investors.
- Class I are no-load funds that do not charge 12b-1 fees. They have very high initial investment requirements.
- Class R are also no-load funds that charge small 12b-1 fees. They are usually for retirement accounts — 401(k), 403(b), and 457.
For more information about mutual fund classes and the associated fees, see our article on how many mutual fund classes are available.
How to Pick Good Mutual Funds
So you know the classes and you know the fees, but how do you pick good mutual funds? Here’s what you need to look for:
Category: The fund category (small, medium, large) says a lot about the potential a fund has to outperform the market. Small funds can more easily produce outsized returns than large funds.
Turnover: Funds with low asset turnover will perform better long-term.
Cash position: Money kept in cash in your funds is earning almost nothing. DO NOT pay for an asset manager to handle cash, you’re better off keeping that money in the bank.
Strategy: When asset managers have more wiggle room to chase interesting securities, it gives your funds a better chance to perform well. Confining strategies can hurt your fund’s performance.
Track record. Ever heard the phrase “history repeats itself”? Pay attention to the success of your funds in the past. While it doesn’t guarantee future success, it certainly shows a good track record of asset management and means there is a better chance of a successful future.
Fees. If you are paying high fees, make sure your funds are outperforming funds with lower fees to make up for it. All funds must be compared on performance AFTER fees and expenses.
To read more about choosing good mutual funds, check out Picking Good Mutual Funds.