You will be able to show, with a worked example, how a yearly cost difference compounds over 20 years.
When Wei Ling first saw her fund's 1.75% expense ratio, her reaction was that it sounded small. Less than two cents on the dollar. Arjun's robo portfolio, at 0.78% all in, sounded smaller still, and the gap between them, about one percentage point, seemed hardly worth arguing about. Most people think this way about yearly costs, and over one year they are right. Over twenty years they are badly wrong.
This lesson shows why, with one worked example you can rebuild in a few minutes. The figures are hypothetical, chosen to make the effect easy to see.
You met compounding in How money works, lesson 2.1, Simple interest pays on what you put in, compound pays on what you earned. Returns compound because each year's growth is earned on a balance that already includes last year's growth.
Costs work the same way in reverse. A yearly charge is a percentage of your balance, taken every year. In year one it is taken from your starting sum. In year ten it is taken from a larger balance. And every dollar taken in year one is a dollar that does not grow for the next nineteen years. So the cost of a fee is not just the fees themselves. It is the fees plus all the growth those fees would have earned had they stayed invested.
That is why a yearly cost behaves like a lower return. If a fund earns 6% before costs and charges 1.5%, your money grows at roughly 4.5% a year, and over twenty years the gap between 6% and 4.5% compounds into a large sum.
Take S$10,000, invested once, which grows at 6% a year before costs for 20 years. The 6% is made up for the example, and nobody can tell you what a fund will actually return. Using the rule of 72 from How money works, lesson 2.3, Estimate doubling time in your head with the rule of 72, 6% doubles money in about 12 years, so you would expect a little over three times the starting sum by year 20.
In a spreadsheet, =FV(6%, 20, 0, -10000) gives S$32,071.35. Call it about S$32,100.
Now take off yearly costs of 0.5%, so the money grows at 5.5%. =FV(5.5%, 20, 0, -10000) gives S$29,177.57, about S$29,200.
With yearly costs of 1.5%, the money grows at 4.5%. =FV(4.5%, 20, 0, -10000) gives S$24,117.14, about S$24,100.
Set out the three results together. With no costs, S$32,100. With 0.5% a year, S$29,200, so the costs have taken about S$2,900. With 1.5% a year, S$24,100, so the costs have taken about S$8,000.
The difference between 0.5% and 1.5% is one percentage point a year. Over 20 years, on S$10,000, it is worth about S$5,060, more than half of the original investment. And the gap widens the longer you hold and the more you add.
A note on method: subtracting the cost from the return, as here, is the simple approach this course uses. In practice costs are taken from the fund daily, and the exact result differs slightly. The difference does not change the picture.
Here is the part that matters most when you choose between options. The 6% in the example is an assumption. Real returns will be higher in some years, lower in others, sometimes negative, and nobody knows the average in advance. The cost is different. If a fund charges 1.75% a year, you will pay about 1.75% a year whatever the market does, in good years and bad.
So when you compare two funds holding similar assets, the return before costs is uncertain for both, and you cannot know which will do better. The cost difference is close to certain. Every year, the cheaper option starts ahead by the size of the gap. That is why cost is the first thing to compare, and why lesson 6.1, Why active funds as a group trail the market after costs, mattered so much: the arithmetic of costs applies to every fund, every year.
This does not mean the cheapest option is always right. A more expensive option might give you advice you would act on, a service you need, or a strategy that genuinely suits you better. Lesson 3.1, What a bank adviser does for the money, made that case. It means you should know the price of those things in dollars, over the time you will hold them, before you agree to pay it.
Wei Ling rebuilt the example in a spreadsheet in about five minutes: one column for years, three columns for the three cost levels. Then she changed the starting sum to what she actually holds, and the 1.5% to her fund's 1.75%. The number at the bottom of that column was the one that made her look at her fund differently.
In the activity below you will recreate the example and rerun it with your own amount, a different return and the costs of a fund you hold.
Recreate the example in a spreadsheet, then rerun it with your own amount, a different return and the costs of a fund you hold.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).