Fees and commissions: How much of your money is actually being invested?
One of the most common misconceptions of casual investors is that all of their money is, in fact, being invested. Sorry people, but that is not the case!
To at least some extent you, as an investor, have to pay in the form of fees and commissions to invest your money. Where is your money really going?
Many of the costs associated with investing are fairly well hidden because they are grouped with overall investment profits and losses. Think of the way that the costs of homeowner’s insurance and property taxes are typically combined with mortgage payments. Just as you don’t write a separate cheque for your homeowner’s insurance, you don’t ordinarily see the direct effects of footing the bill for investment fees as separate transactions. But that doesn’t mean that they aren’t there. Oh yes, they are definitely there.
The key principles involved in tracking the costs associated with investing are:
- Do you use an investment advisor?
- If you do use an advisor, what is his/her method of compensation?
One of the first questions I always tell people to ask a financial advisor before you hire them is “How do you get paid?“. Asking that simple question will demonstrate how upfront that advisor is. If you don’t understand his explanation, it’s time to find a new advisor immediately.
When you choose to use an investment advisor of any kind, you are essentially paying for that person’s financial expertise to aid in guiding you to make good investment choices. In other words, the investment advisor is going to be paid, somehow.
Even if you don’t use an advisor and invest on your own with an online broker you will still incur a trading fee every time you purchase or sell a security. These trading fees are relatively small—usually in the neighborhood of $5-10 per stock trade—but the cost can add up quickly, particularly for someone with an extensive, active portfolio.
And, of course, without the services of an advisor, you’re on your own when it comes to investing. This is something that can be extremely intimidating, not to mention financially risky for casual, inexperienced investors. Even low risk investments require you to do your homework before handing over your money.
Fee systems for investment advisors
There are three basic systems of compensation for investment advisors:
- Flat rate per-hour charges: Using this method, an advisor is paid for the number of hours of research and work done to implement financial advice, based on a pre-determined per hour rate. These advisors are usually referred to as “fee-only advisors“. This approach has the benefit of objectivity; since the advisor doesn’t benefit personally from any particular investment and has no incentive to encourage active trading, he/she is more likely to consider a wider range of investment options and concentrate on a plan that best fits that of each individual investor in terms of available assets and comfort with risk-taking.
- Transaction-based commissions: This is the traditional form of investment advisor compensation and is used by essentially all the large investment firms. This method calls for the advisor to receive a commission every time an investment is bought or sold. The potential for conflicts of interest here are obvious, as the advisor has a clear incentive to push the client to constantly buy and sell, whether that is in his/her best interests or not. While “churning”—the process of trading for the sake of trading to earn commissions for the advisor—is technically illegal, it does happen and it’s very difficult to prove.
- Asset-based fees: With this form of compensation, the advisor earns a percentage fee based on the value of the investor’s account. By this method, the better the investor does, the more money the advisor makes. Giving the advisor every incentive to work for the investor’s best interests is the main attraction to this method. The only real potential downside is that the advisor also has an incentive to encourage the investor to place as many assets as possible at his/her disposal.
Know what you’re paying for
It’s worth the time it takes to check the “fine print” and determine where your investment money is going—not just the investments themselves, but the hidden fees and commissions as well. You’ll not only have a better sense of the actual expense of investing, but you may have some insight into your investment advisor’s motivations as well.