The Tyranny Of High Costs

Cost is a key factor in many of our purchasing decisions and while the extent of its impact on decision making may differ, we all want to ensure we are getting sufficient value for our hard earned cash.

For a potentially complex purchase decision, we need look no further than the supermarket shelves. We’re faced with endless variations of the same basic product – variances in fat content, branding, and size – but in the end, a 10-second scan of the available options is usually all it takes before many of us short cut the process.

The supermarket may give us an often overwhelming level of choice but our short-cut decisions are unlikely to prove life-changing. Making investment decisions is both more complicated than what faces us in the aisles of our local supermarket but also likely to have more impact on our future lifestyle so it is worth considering what factors influence our decisions and how they differ.

As the significance of a purchase increases, we tend to more seriously consider a broader range of factors. Individuals will undertake different levels of research and due diligence before making investment decisions.

Complexities outside investors’ control such as market volatility, interest rate movements, currency fluctuations and government policy all have an impact , and therefore come into play when making decisions about investments – but what weighting should be given to cost?

How cost applies to individual investment products and superannuation is regularly debated and is a hot topic in Australia at present. As is often the case with significant purchase decisions, some will make the argument that higher cost equates to higher value.

The opposite has proven to be true.

The impact of reducing costs can be demonstrated in a simple, but powerful, example – looking at the growth of a $50,000 investment with $5000 annual contributions and earning 6 per cent per year.

First let’s assume fairly typical annual fees of 1.20 per cent, a representative average cost paid by Australians investing in domestic or international funds. Over a 30-year period this investment would grow to $494,000.

In the second scenario significantly lower costs of 0.25% are assumed, a realistic figure using low-cost index funds or exchange-traded funds. The result for the same initial investment with the same annual contributions and returns over the same timeframe is a tidy $655,000.

The outcomes of these two contrasting, but very real, scenarios is staggering. With less value eroded by high-fees, and spurred on by the power of compounding, the low-cost investment grows by $161,000 more over the 30 years.

Given the reams of research consistently demonstrating the difficulty of achieving performance above the market return, in both of these cases, no "alpha," or outperformance was assumed.

While this might seem like a significant caveat it is actually a fairly conservative assumption given the volume of research consistently demonstrating the difficulty of achieving outperformance. One example is SPIVA’s latest report on the performance of actively-managed Australian mutual funds which found that over five-year periods "the majority of active equity funds in most categories fail to beat their comparable benchmark indices."

There is no limit to the amount of time that we can spend analysing market predictions and pouring over the daily headlines on economic forecasts in an attempt to make informed and shrewd investment decisions but the simple reality – as Warren Buffet consistently says – is that beating the market return is very, very difficult to do over the long run.

A more valuable use of this time would be to set our minds to developing a comprehensive financial plan and setting strategic asset allocations to help meet long term goals and – when it comes to investment selection – giving more weight to those things that are within our control, like cost.

Robin Bowerman is Head of Market Strategy and Communication, Vanguard Australia. As a renowned market commentator and editor Robin has spent more than two decades writing about all things investment.