One of the most entertaining scenes in the movie ‘Wolf of Wall Street’ is when Mark Hanna (played by Matthew McConaughey) explains to new recruit Jordan Belford (Leonardo DiCaprio) how stockbroking business works over lunch of martini and cocaine.
“F*** the clients. Your only responsibility is to put meat on the table. The name of the game is to move your client’s money into your pocket.”
“But if you can make the client some money it’s advantageous to everyone, correct?” Belford replied.
“No,” Hanna quickly answered.
“Number one rule of Wall Street: Nobody, I don’t care if you’re Warren Buffett or Jimmy Buffett, NOBODY KNOWS if a stock is going to go up, down, sideways or in circles, least of all stockbrokers… It’s all a fugazi— It’s fake,” Hanna explained.
“Clients are addicted to trading, and the challenge for the broker is to keep coming up with brilliant ideas to keep them trading again, again and again.”
“The client thinks he is getting rich, but in fact, it’s the broker who’s taking home the cold hard cash via commissions,” Hanna added, smiling profusely.
Of course, this is Hollywood’s depiction of how Wall Street works— it was designed to sell tickets.
But what many investors don’t realize is that what was depicted in the movie is frighteningly close to reality. Unscrupulous salespersons, brokers, and investment advisors could be feasting on their portfolios in the form of high fees and commissions.
And we’re not only talking about individual stocks. A typical retirement portfolio comprising of mutual funds could also be subjected to high costs— potentially eating your returns.
The impact of high fees and commissions
Belford may have gotten a free lunch at the Windows of the World restaurant from his boss. But as with anything else you buy, there are fees and costs associated with investment products and services.
Assuming an investor put $100,000 into a stock mutual fund 20 years ago. The fund earned an average annual return of 8 percent. Today, the account should have grown to $424,785— if it were purchased directly from the fund company, on a no-load basis, with a minimal 0.5 percent annual fee.
However, your investment adviser can sell you the same exact fund with a different fee structure, in the form of mutual fund classes, which they can use to their advantage.
If an “adviser” sold the same investor the Class C shares that don’t have an up-front fee but charges a much larger annual fee of 1.8 percent— along with potential “back-end” fees (if you sell within one year), the investor would have gotten a really ugly deal.
The result would be a portfolio with an ending balance of only $333,035— a $91,750 difference!
Now imagine the impact these fees would have on a million dollar portfolio.
How to control investment costs
Don’t get me wrong. Investment fees and commissions aren’t all bad. Wolves need to eat too. You just want to make sure you’re getting good value from your investment without letting them feast on your returns.
Good value means you are getting your money’s worth via the fund’s performance relative to the benchmark.
Understand the fees before you invest
Review the rules and read the investment prospectus. Be sure to ask about all fees— they add up very quickly.
- Trading fee ($4 to $9 are common)
- Expense ratios of mutual funds (0.04% or less to 1.5% or more)
- Sales charges: Front or Back-End Load (1% to 5.75%)
- Marketing or distribution 12-b1 fees (0.25% to 1%)
- Administration fees (very common for 401K and self-directed IRA)
- Assets Under Management fees (industry average is 1.67%)
Most of these fees can be avoided or minimized. You can avoid sales charges by sticking to no-load mutual funds, for example.
As a DIY investor, I don’t pay A.U.M. fees. If you do need professional help, I’d suggest you seek a Fee-only Investment Advisor who has a fiduciary duty to act in their clients’ best interest. They do not accept any fees or compensation based on product sales.
Low-cost index funds are your best friends
Index funds have a much lower cost because there’s no need for human oversight— they track a market index like the S&P 500 as the benchmark. Hiring and firing fund managers can be expensive.
Vanguard index funds, in particular, have low fees because it has no outside investors— the company is owned by its fund. The expense ratio of the Vanguard Total Stock Market Index Fund (VTSAX) is only 0.04%, for example.
Time and time again, most actively managed funds fail to beat their benchmarks. Finding an actively managed mutual fund that can consistently beat the market over a long period of time is like finding a needle in a haystack.
Foreign stock funds and bond funds could be the exception. So I wouldn’t dismiss actively managed funds altogether.
Avoid active trading
The reason active investors lose money is that they’re not really investors— they’re speculators. Like gambling, frequent trading can be addictive. Trying to beat the market by picking individual stocks, day trading, or timing the market are all recipes for failure.
Think twice before investing in individual stocks. To be successful requires skill, upfront, and regular research. They can also be extremely costly and difficult to manage on your own.
It’s no secret brokerage firms love active traders. Even at low commission rates, investment firms make billions in trading fees. Trade only when it makes sense for your portfolio.
Be wary of experts offering advice. Remember, a blindfolded monkey throwing darts at a newspaper’s financial pages can pick stocks just as well as the “experts”— at least according to famous economist Burton Malkiel.
So never ever join subscription-based investment clubs that provide stock recommendations based on stupid technical analysis or price targets.