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Investor Information: Tyranny of Costs

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There are mainly three facilities one may use to invest in equities on the stock market, namely:

  • Through an approved stock broker
  • Through available funds, such as Collective Funds (Unit Trusts), Hedge Funds, etc.
  • Through on line stock trading platform facilities as offered on the Internet.

Each of these facilities has different advantages and disadvantages and which one to choose will very much depend on your own expertise and knowledge of the equity markets.

The most important issue, however, which is often neglected or ignored by investors is the cost aspects applicable to these different facilities.

Whilst almost all private investors (retail investors) have a solid grasp of the "magic of compound interest" as it relates to future yields, very few seem to really grasp the "tyranny of compounding costs" and its impact on eventual return when choosing a trading facility.

If one uses a worst choice scenario over a really long-term the impact of this tyranny of compounding costs can be devastating to the potential yield of such an investment.

For Example:

  • If one invested R100 000 and obtained an average annual yield of 8% via a facility where a 5% initial fee and an annual 2% intermediation fee were charged over a 65-year period, the sacrifice in profits during such a period is almost unbelievable.
  • In the above "worst case" scenario the end value of the investment after 65 years would have been R3,084,135, but if there was no initial fee or intermediation fee applicable the end value would have been a staggering R14,877,984 (4.8 times more).
  • The actual sacrifice of potential profits made amounted to R11,793,849 or to put it differently, the fees charged in this bad scenario resulted in the investor at the end of the term only receiving 20.7% of the actual profit earned.

It is surprising to see how few average investors really understand the extent of the impact of factors, such as investment term and yield difference between a 10% annual compound yield and a 20% annual compound yield.

As unbelievable as it may seem, you still find investors who seem to think that a 20% annual return is only twice as good as a 10% annual return.

Make no mistake, if you are investing for the long-term even 1% can make a massive difference to your eventual
yield or profits.

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To illustrate the extent of impact different percentages may have on an investment, let us look at the situation where one invested a lump sum of R100,000 for 30 years and for the sake of simplicity we assume no costs were charged.

  • At a 10% annual compound yield your investment will yield R1,744,900
  • At a 12% annual compound yield your investment will yield R2,995,900
  • At a 20% annual compound yield your investment will yield R23,737,600

Therefore, a 20% return over the above period is actually 13.6 times better than a 10% return.

Certain cost elements should be considered when choosing an access facility to the equity markets, namely:

  • The actual trading costs when a transaction takes place on the FTSE/JSE
  • The (up front) initial fee charged for access to or providing the facility
  • The annual intermediation fees charged for managing a fund or portfolio
  • The annual fixed membership or administration fees charged or involved

The latter fee has the least impact on the outcome of an investment mostly because it is not related to the size or value of the portfolio.

For example, the R1,500 annual Valana subscription fee on a portfolio of R500,000 represents a charge of as little as 0.24%.

The ideal scenario when choosing an equity investment facility will be one where you make your own trading decisions, either through a registered broker with no mandate to trade on your behalf, or through an on line trading facility.

Any method where you can avoid intermediation fees being charged that will erode the profits in your portfolio is strongly recommended.

To really grasp the impact of the three most important elements of an investment namely, compound growth obtained, term of investment and tyranny of costs, let us assume that R100,000 was invested at a gross average annual yield of 12% over three different terms and let us compare it using different platforms or facilities for such an investment.

Also, let us assume that except for the first two situations an average dividend of 4% was earned each year on the funds invested in the equity markets.

To illustrate the impact the table below shows the approximate outcomes obtained:

Situation applicable 50-year term 40-year term 20-year term
Investment free of costs and no dividends R28,900,000 R9,305,000 R964,600
Investment Fund with fairly high costs R7,222,000 R3,027,700 R533,861
One could argue that the overall yield should be higher as the dividends received by the Fund are included in the NAV growth of the Fund, but our experience found little evidence of it being so.
Dividends not reinvested and zero costs R39,652,300 R12,741,700 R1,287,400
Dividends reinvested and no other costs R205,384,700 R44,673,900 R2,113,600
Added yield if dividends reinvested 417% 250% 64%
Over the long-term, it would be very hard for any investor to beat a portfolio of quality dividend stocks where such dividends are reinvested during the term.
If no intermediation fees applied R31,675,600 R10,533,200 R1,144,200
If a 2% annual intermediation fee applied R12,121,167 R4,923,500 R790,200
If a 3% annual intermediation fee applied R7,492,200 R3,365,800 R656,560
Profits sacrificed (re high and low above) 76% 68% 42%
The question one has to ask oneself is whether the benefits, if any, obtained from giving a broker a full mandate is worth sacrificing such a large portion of one's profits.
Expert trading direct on line with low costs R34,937,000 R11,420,000 R1,198,400
Giving broker a full mandate (small account) R10,000,000 R4,213,000 R720,700
Giving broker a full mandate (large account) R12,449,700 R5,030,400 R799,150
There can be little doubt, for you to enjoy most of your profits you need to be an expert with sufficient expertise and knowledge and you will need the time to do in-depth review and analysis.
Using Valana source and on line trading R32,048,400 R10,490,800 R1,114,000
With the correct application of the Valana facility one can almost be in the same position as the expert trader without needing all
the expertise and without doing any of the homework done by such an expert.

From the above it should be clear that unless you are an expert on the markets and unless you have adequate time, skills and knowledge to analyse and select your own companies to invest in, the Valana model will probably be the most effective manner to enjoy better profits.

Brokers will, of course, be very quick to tell one that the annual intermediation fee they charge, where a full mandate applies, is for the good advice and stock selection recommendations they make and to some extent it is true, but you should decide whether you are prepared to sacrifice so much of your potential gain for this advice.

Research clearly showed that stock brokers are essentially more sales-orientated than they are good stock pickers. After all, their primary function is to get clients to trade as often as possible.

From the experience our team had during the past ten years with several broker houses, we came to the conclusion that although they mostly had good knowledge of the markets, they did not always demonstrate convincingly that they have the ability to select really good stocks.

They also tend to focus on the few popular liquid or large cap stocks and they seem to sell good stocks too soon.

The most important thing to realise is that they could never care about your money the same way you do.

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