Investing as a Student 2: The Risk of Fees

This is a follow-up to my post on investing for students. I am learning a lot in my Com 371 finance class and realize how important it is that we all know about basic investing.

When you invest money, you get a better return —  you’re paid more for taking more risk. Risk is the probability of losing your money. This is a basic investing principle.

However, the risk you are paid for assumes that you have a diversified portfolio (a bunch of different investments that respond differently). If you buy a single stock when you are starting out (like shares in Apple or Microsoft), you are not being compensated for all its risk. Because of this, it is common for new investors to start with a mutual fund (a large portfolio of stocks with many investors contributing) or an Exchange-Traded Fund (ETF).

Mutual funds allow you to diversify and decrease your risk without having to spend a lot of money. The problem with this, though, is that the fund managers take a cut on the fund’s earnings. Once again, you aren’t being paid for all the risk you have taken.

Photo by pina messina on Unsplash

Instead of starting with mutual funds, ETFs provide a similar service – a diversification of risk – with a very minimal fee. For example, an average mutual fund may take 2% off the earnings each year while an ETF would only take .18% on average. This is ~10 times smaller and saves a large sum of money over time.

Let’s assume that you invest $ 20,000 over 30 years in each of these funds. If both the funds made an average of 8% return with semi-annual compounding, the ETF would become $200,138.06 while the mutual fund only would grow into $120,186.94.

This change occurred solely because of fees. The financial advisor selling you the mutual fund would be very happy with the approximately $80,000 that they made from your money.

To prevent this from happening to you, make sure you ask about fees when you are starting to invest. Knowing that these fees dramatically impact the end results of your investments gives you the capacity to make better choices. If the mutual fund is performing better than the ETF, then it may be worth the resulting fees. There are many factors involved in investing but being aware of fees may allow you to make better choices.

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