Stealth costs that are legal
Anyone who has ever entered into a discussion with me about investing (whether as a client or innocent bystander) will know that I feel very strongly about the costs associated with accessing investments and financial advice or products in general. I am passionate about not paying for a service I do not need or overpaying for a service that I do need.
The cost of actively managed funds can be exorbitant especially when the active manager struggles to outperform the market inclusive of the fees. Frequently it is in fact the fees that cause active managers to underperform the benchmark index and or passive investment funds. When you add on advice fees, and although less prevalent these days, initial fees, you have little hope of achieving real growth in your assets even if you take on higher risk assets to achieve higher returns.
The fact that there are advisors in today’s industry that charge an initial fee plus an annual ‘advice’ fee is both saddening and annoying when they do not actually provide any ongoing input into the investment process. I get especially annoyed when this happens on cash or money market investments! The winds of change are blowing however. Industry participants are changing their offering and regulatory and statutory improvements are in some ways forcing more ethical behaviour. It is now possible to access investments in a far more cost efficient manner, thereby increasing your chances of achieving your financial ambitions if you know where to look.
But before I dive headlong into another rant about fees (plenty of time for that), there is another hidden cost that most investors never even consider. It is not the job of an asset manager nor even FAIS and all the regulations to highlight this cost to you but it can have a very heavy impact on the success or failure of your financial plan. I am talking about opportunity cost.
DEFINITION : OPPORTUNITY COST – The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action. (Source: Investopedia)
It’s a simple concept to grasp and many of us already put it into practice in one form or another on a daily basis. However it often remains just a concept or a theory when it comes to the true impact on your financial well being. So let us use a real life example in the hope that the impact can hit home a little harder and that your future decisions will be made with a deeper understanding of the true cost and impact on your financial well being.
A client opted to go on a skiing holiday in February of this year. She pointed out that it was a once-in-a-lifetime spoil and since she had been so diligent in her savings over the past year she felt justified in the decision. A little look at our Opportunity Cost calculator* gives us an idea of the long-term impact of this decision.
The budget for the trip was set at R30 000.00 which is not bad for a week-long trip of that nature. Unfortunately the trip was only funded using cash of R10 000.00 while the remaining R20 000.00 had to be funded using an unsecured loan which is one of the costlier forms of borrowing. In this case the rate charged was 24% per annum. From her current budget the client calculated that she was able to put R1500.00 per month aside as payment on this loan.
From Figure 1 we can see that the R20 000.00 loan would be paid off in approximately 1.44 years or 17 months on the terms outlined above. The actual cost of the trip after the finance or loan repayments are taken into account is actually R35 953.01. (Almost 20% higher than originally budgeted).
But now if we assume she had foregone her trip altogether and committed that money to a savings account what would she have as cash in the bank after the 17 months?
Assuming she was able to achieve a 4.3% (not an unreasonable assumption) annual return she would have accumulated a total of R37 949.94.
This figure is made up of the original R10 000.00 plus approximately 17 months of additional R1 500.00 contributions and interest income of almost R2 000.00 – a hefty opportunity cost on its own.
But what if she was now to take this R37 949.94 (we ignore tax on the income in the spreadsheet) and invest it into her long term retirement annuity?
If she was to earn an average return of 9% a year for the next 25 years on this money it would equate to additional retirement savings of R 327 245.41. In today’s terms that is a whopping R76 247.73 OPPORTUNITY COST of going on that holiday!
Now before you jump down my throat about how boring life would be if we never did anything spontaneous and if my client were to die before retirement then surely the skiing trip would have been worth it – I hear you! I know on our deathbeds the size of our pension pot will be dwarfed into insignificance by the question of whether we really lived life to the full or not.
But successful financial planning should be about finding a balance in your life between living in the present and planning for the future. A successful financial future is the function of tough choices today, forward looking decision making and fighting the urge of instant gratification each and every day.
My mother used to tell us when we wanted to buy a motorbike that we should visit the hospital and see bike accident victims firsthand before making a final decision! Using that logic there are plenty of examples of pensioners out there who simply cannot meet their daily expenses – you need not look far to see the trauma of financial distress in ones ‘golden’ years. The low self esteem brought on by feeling unwanted in the work place, unable to provide for yourself and being a burden on those who love you is soul destroying. All I ask is that you consider the opportunity cost of your spending habits today and give yourself a fighting chance of a future free from financial distress.
*If you would like a copy of White Investment’s Personal Finance Kit spreadsheets simply send us an e-mail at firstname.lastname@example.org
Please contact White Investments if you would like to learn more about the ways in which we can partner with you to a more secure financial future.