8. Math break: the impact of fees

How significant is an annual management fee of 1% or 2%? It looks minuscule compared with other rates we're dealing with when it comes to our finances: from sales tax (5%) to credit card interest (10-20%) to income tax (up to 36%).

We tip a waiter 15-20%. How bad can it be to give up a meager 1% or 2% to have a professional manage your finances? Don't they deserve this small token of appreciation? 

Check this simple calculation. Assume you start with $10,000 that grow by 5% annually for 30 years. With no fees at all, you'll end up with $43,219. With 2.5% annual management fee you'll end up with $20,976, or less than half.

The assumptions leading to this surprising result are pretty mild: 5% annual return net of inflation, and a long investing horizon. True, an annual fee of 2.5% is pretty extreme, but even a 1% annual fee will reduce your savings by a quarter. And when index funds charge as low as 0.07% annual fee (check SCHB for instance, my choice for a broad-market US fund), there's no reason to give half your money to middlemen. Not even if they really, really need to upgrade their yacht. 

Bogle points in his excellent book that mutual funds trail, on average, the S&P 500 by 2% annually, which happens to be their average management fee. In other words, the average mutual fund will give you long-term returns that are 43% below the index. Still want to invest in actively-managed accounts? No worries, I, and other passive investors will thank you.