Last week we talked about the Time Value of Money, and why it’s important to invest your money. This week, we’re discussing percentages, how they affect your finances, and why they matter.
What's in a percentage?
When we talk about your investments and how well your investments are doing, we normally talk in terms of percentages.
You may have heard phrases like, 'the TSX is up 1.7%' or 'your investments are up 8%', or 'your investments are down 3%'.
In fact, there are many ways that the financial industry can present percentages. Unfortunately, depending on how percentages are used, they can also mean radically different things, so it's important to know what you're looking at.
Before we get started, a quick primer on interest:
Simple Interest: Simple interest paid or received over a certain period is a fixed percentage of the principal amount that was borrowed or lent. AKA - the interest amount is the same every single year!
Compound Interest: Compound interest accrues and is added to the accumulated interest of previous periods, so borrowers must pay interest on interest as well as principal. AKA - the interest grows every single year, because the baseline number you're being charged interest on increases by the previous interest amount every year.
Let's look at an example. Say you invested $100. What would this look like at a simple vs. compound interest rate of 10%?
Now that you're all caught up on interest, let's see how this affects your financial decisions.
Understanding percentages helps you clearly see how well your investments have been doing.
A lot of the time, banks, funds, investment companies, and essentially any place you have your money invested, will want to try to convince you their financial products are performing better than they actually are.
Let's see how Questwealth (the robo-advising arm of Questrade) does it. This is the returns page of the Questwealth Balanced Portfolio. You can see there are a ton of different numbers here, and of course, they all mean different things (spoiler alert: some numbers are more helpful than others!).
Let's dive in.
Cumulative Returns: *Least helpful* These numbers describe the overall growth (in a percent form) over a set period of time without breaking down how much was gained every year.
So in the example to the right, over the last year your money would have made 6.37%, and over the past 5 years your money would have made 45.87% (called your return - which is short for return on your investment). For the same 5 years the compound interest is 7.84%
45.87% sounds fabulous! And this is why the company describes how your money has grown this way first. This is not using compound interest. The compound return is on the bottom.
Calendar Returns: *Kinda helpful* These numbers look at how much your money went up or down between January 1st and December 31st of a particular year.
Looking at the example below, if you had invested in this fund then in 2014 you would have earned 9.24% on your money. In 2015 you would have earned 2.03% on your money. And so on.
(YTD stands for Year To Date, and describes how much they've earned so far on your money in 2021)
Compound Returns: *Most helpful!* These are numbers that show a single compound percentage (like we described above) that you could apply year over a year to get to your current balance. It smooths out the swings in your investments and says, ‘if I had a consistent percentage compound return, what would it be?’.
For different years, these numbers are the ones that you can use to make apples to apples comparisons on how Questwealth (or similar) is managing your money. These numbers can also help you understand if you’re on track to meet your retirement goals.
Let's say that your financial plan uses 6.0% return on your investments to reach your retirement goal. In this case we can use the 5 year 7.84%, and see that 7.84% is bigger than the 6.0% you need to reach your goal, and know that you're on track. You can also compare the 7.84%, with what you could earn by investing in other options (other option performance minue other option fees) to see if you're happy with your current provider.
Keep in mind that there is a link between how much risk you take and how much you can earn, so the more you earn the more likely there will be bigger ups and downs in the calendar returns.
Percentages help you see how much in fees you're paying for your investments, and allow you to make comparisons to decide what's best for you.
When you invest in a fund or in a portfolio, there will be fees that you pay. There are often two sets of ongoing fees*.
Account Fees: What you pay to the service provider for the account (this could be the bank or the financial institution or the robo-advisor where you keep your investments, in our example, it would be Questwealth).
Product Fees (known as MERs - management expense ratios): The fee you pay for the product you're invested in (examples of products are portfolios, funds, ETFs, mutual funds, etc.). In Canada, these are subtracted before posting the performance of the fund.
Sticking with our Questwealth example: At Questwealth, the account fees are 0.25% and the product fees are another 0.13%. Meaning that you pay 0.38% (0.25% + 0.13%) every year to be invested in their portfolios. These are the lowest account and product fees that Untangle has seen in Canada.
The average mutual fund fee in Canada is 2.53%. While this fee is deducted before you see the performance of your fund or portfolio, you are still paying the fee, and a high fee makes it harder for your fund to perform strongly compared to other options that have lower fees.
Remember when we discussed inflation in our Time Value of Money blog, and we learned that even with just a 2% rate, the value of our money is cut in half every 35 years? Small percentages matter. Let’s say you invest $100 and have a fee of 2.53%. Over 35 years, the fee will have earned the provider $140. This adds up to more money than you originally invested. Small fees can make a huge difference.
*There are also one time fees that you need to be on the lookout for - these are called sales charges, and in our opinion, have no place in the marketplace and should have been outlawed years ago for predatory practices in the industry. However, they do still exist. If you are offered a product with Front-end load or initial sales charges (ISC). Or, back-end load or deferred sales charges (DSC) you should run away as fast as you can. If you have these products already, get in touch and we can talk you through some options.
So why do percentages matter?
In a nutshell, they allow you to make better financial decisions. Having a clear understanding of things such as the fees you’re paying your investments, as well as the compound returns on your investments, allows you to calculate whether your investment is actually working for you! But hold on, there’s one more thing we need to talk about!
There's a secret here, and it's called inflation. Remember, inflation is the rate at which the value of a currency is falling and consequently the general level of prices for goods and services is rising.
You need to make sure you take inflation into account when looking at the returns of your investments. This is because you need your money to grow by the amount of inflation at a minimum so the growth in your money offsets how much the value of the money falls (in Canada, it is generally around 2%).
To understand how well your investments are really doing, and whether they are working for you, the formula looks a bit like this:
Take the amount of compound return as a starting point
Subtract any Account Fees that you pay to the institution where your account is (remember, small percentages differences make a HUGE impact here)
Subtract the value of inflation (in Canada, that’s roughly 2%)
Now you can see how much money you’ve actually earned from your investments! If it doesn’t match, time to look for a new investment!
Said another way, if inflation is 2% and the Account Fee is 0.5% (like WealthSimple), then you need to earn 2.5% just to stay where you are from a finance perspective.
Here are some actionable steps:
Make sure when you're speaking about your investment performance they are referring to compound annual growth rate.
Understand that seemingly nominal changes in fees on your investments (e.g. a mutual fund with a fee of 3% vs. an ETF with a fee of 1.5% will likely have massive impacts to the money you get in your pocket because these fees accumulate over time).
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