When it comes to investing, I often challenge investors to understand and be aware of what rate their money is growing. Unfortunately, many investors simply don't ask this question. In addition, financial institutions are not required to reveal to consumers the actual rate of returns on their money.
Several factors complicate matters.
- The dates of deposits are not taken into consideration
- Clients may have monthly or bi-weekly deposits
- Class A sales charges
- 12b-1 fees and other hidden money management fees
- account maintenance fees and other hidden account fees
- Selling or rebalancing
- Misunderstanding of interest rate calculation
Meet Mary. On May 31st, 2013, Mary spent $14,995.87 to purchase stock within a diversified portfolio. On May 31st, 2015, Mary checked that here account balance was $14,950.94.
Mary decided to go to her financial organization and ask them what her interest rate was. Her financial adviser pulled up Morning Star, looked at her particular holdings and gathered two year history. Based on a $10,000 investment, Morning Star showed the performance of the last two years would grow to $10704.35. This is a rate of return of about 0.0346 or 3.46%.
Mary's financial adviser told her this portfolio grew 7.04% over the past few years, which was what Morning Star showed. However, Mary knew that in order to compare her rate of return with other investments, she really needed the annual rate of return, as opposed to the total rate of return. The statement, "My money grew 350%" does not mean much, since context is everything. "My money grew 350% over the past year!" is much different than "My money grew 350% over 75 years."
Mary's financial adviser told her this portfolio grew 7.04% over the past few years, which was what Morning Star showed. However, Mary knew that in order to compare her rate of return with other investments, she really needed the annual rate of return, as opposed to the total rate of return. The statement, "My money grew 350%" does not mean much, since context is everything. "My money grew 350% over the past year!" is much different than "My money grew 350% over 75 years."
This did not make sense to Mary since her account balance was less than the amount she initially used to purchase stock. She discovered that one of the major fees she paid was a Class A Sales charge. This was a one time fee she remembered paying two years ago. She remembered the fee was 5.5%. This meant her actual initial holding should have been $14,128.64. Mary decided to check her account history. When she pulled up her records, she found that her initial holding from May 31st, 2013 was only $14,079.80! This meant that even though she was told the fee was only 5.5%, after hidden fees, she ended up paying closer to 5.8%!
Mary decided to just check the growth of the account after the initial fees. Her money grew from $14,079.80 on May 31st, 2013 to $14,995.87 on May 31st 2015. This is a rate of return of about 0.0320 or 3.20%.
Unfortunately, Mary discovered her financial adviser was quoting growth at 3.46%, when it was actually closer to 3.2%. Her financial adviser was also quoting the sales charge at 5.5%, when it was actually closer to 5.8%.
Knowing this, Mary decided to keep the investment because the stock portfolio was at least keeping up with inflation and retaining purchasing power, one of the reason's Mary decided to invest in the stock in the first place.
However, after speaking to me, I encouraged Mary to calculate her rate of return based on money in and money out. That is, I advised her to ignore the reporting and findings of the financial institutions. I encouraged her to track how much money she deposited before any fees and how much money she could withdraw after any fees. This was her real rate of return and she should track this year in and year out. Gathering a track record of five years might help her to make better investment decisions in the future and understand the performance of stock better.
She did this. It turns out her rate of return was about -0.000061 which is in the negative but basically 0%. I told her that the growth of her stock portfolio over two years had basically covered the initial sales charge.
This is why investors should take a long term approach, avoid moving and transferring money too often and not invest with money that is needed to cover basic expenses.
This is why investors should take a long term approach, avoid moving and transferring money too often and not invest with money that is needed to cover basic expenses.
