Thursday, July 27, 2006

Principle #4 - Avoid Unnecessary Erosion of Value

Investments are vulnerable to many evils. Among the most insidious are fees, charges and other things which, at first glance, appear to be small and insignificant. In reality, they are neither small nor insignificant and can have a massive negative effect on the value of investments. Ultimately these "small" things can have a material adverse impact on when and how you retire and your standard of living.

Let's look at some examples.

1. Front end load. If anyone tries to sell me an investment that has a front end load, my immediate reaction is to invest somewhere else. If you have a choice between two investments: Fund A and Fund B. Each fund is projected to earn 8% per annum compounding monthly. Fund A has no load. Fund B has a 1% front end load. You decide to invest US$500 per month into each fund. The amount of your investment will be increased in line with inflation of 3% per annum. That sales charge doesn't look too bad does it? It's only $5.00 per month. Fast forward 30 years to retirement and we see that the value of your US$180,000 investment in Fund A has grown to US$1.225 million while the value of Fund B has grown to US$1.017 million. That US$5.00 per month made a big difference in the end. Similar principles apply to management fees and any other charges that are being deducted from your investments. Fight these things.

2. Idle money. I am frequently guilty of leaving money lying around. No, not in stacks for my children to play monopoly with but in bank accounts that either earn sub-optimal rates of interest or, worse, none at all. Money comes in from a variety of sources and ends up in various bank accounts in different currencies (one of the joys of being an expat). Eventually it gets utilised, but often it takes time - typically months - before I get around to using it and even longer before I use it in the most productive manner. In one case I found I had several hundred dollars sitting in an account earning no interest for nearly a year. None of the amounts are large (possibly excepting my salary and term deposits at sub-optimal rates). However, if I add them all up, take into account the time the money is sitting unutilised or underutilised, look at what the money could have done had it been applied more productively and factor in the effects of compounding, the numbers are very meaningful. In my particular circumstances, I worked out that over a ten year period more efficient management of cash balances could have reduced the term of one of my mortgages by a several years. Over a twenty five year period I could just about have purchased a (very) small investment flat and repaid the mortgage. How much difference to your retirement would the income from an additional investment property make? That's decent holiday in Europe each year for Mr and Mrs Traineeinvestor.

I now regularly spend time reviewing the small stuff. I sweat the small stuff. Take a few small gains here and there, add the power of compounding, and the results can be truly impressive.

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