The Wall Street Self-Defense Manual, Part 3.

The Wall Street Self-Defense Manual, Part 3.

The Wall Street Self-Defense Manual, Part 3.

How to understand Wall Street.
July 22 2004 7:09 AM

The Wall Street Self-Defense Manual, Part 3: Your Real Projected Returns …

…. after fees, costs, taxes, and inflation.

Read Part 1 of the Wall Street Self-Defense Manual here and Part 2 here. Read Henry Blodget's detailed disclosure statement here.

Illustration by Robert Neubecker.

So, depending on whose projections we believe—mine or the brokerage firm's—I can expect value generation to the tune of 4 percent or 9 percent per year over the next 10 years. Right? Wrong.

Why? Because the projected returns we have examined so far are, for the most part, before costs, fees, taxes, and inflation. When the stock market goes up 20 percent-plus per year, as it did in the late '90s, costs don't matter much (or, rather, don't seem to matter much). When the market rises only a few percent a year—or, worse, drops—they matter a lot.                     

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Let's start with transaction costs. Most of our projected returns are market returns, not fund returns. Unfortunately, you can't buy "markets." All you can buy are securities and funds. All funds generate transaction costs, even "passively managed" index funds. An S&P 500 index fund, for example, acquires the stocks in the index and then continually buys or sells shares to maintain the appropriate balance. When the fund trades, it pays brokerage fees, just like the rest of us. John Bogle, the founder of Vanguard and author of Common Sense on Mutual Funds, estimates that, on average, transaction costs eat at least half a percentage point of annual return.

Next come fees—fees charged, in this case, by the brokerage firm and the outside managers who actually run the money (the firm suggested dividing my assets among several outside managers, including some that manage other managers—so-called "funds of funds"). Asset management fees often seem immaterial: "One or two percent a year? Who cares?" In fact, they are often outrageous. The fees on my proposed program ranged from 0 percent on cash to an astronomical 3 percent-plus on funds-of-funds. In aggregate, this amounted to about 1 percent of assets, which is painful but (relatively) reasonable. The fees on low-cost funds like Vanguard's run from 0.2 percent to 1 percent—some of the best deals in town. The fees on generic "full-service" mutual funds can run as high as an absurd 2.2 percent or more.

Then we come to the biggest expenses: taxes and inflation. Most investment gains, interest, and dividends are taxed. Because taxes can take an eye-popping bite out of performance, investment advisers usually aren't in a hurry to show you projected after-tax returns. This is unfortunate, because, in most cases, the only returns that matter are after-tax, and pretax returns aren't created equal. Thanks to some tax laws (interest deductibility), a 5 percent yield on triple-tax-exempt municipal bonds can be worth more than an 8.5 percent yield on corporate bonds. Thanks to other tax laws (short-term vs. long-term capital gains), a 5 percent return on an index fund can be worth more than a 7 percent return on an actively managed stock fund. After-tax returns depend on the asset class and the investor's circumstances (tax bracket, state of residence, etc.), but they also depend on the manager's tax efficiency: Some funds generate higher after-tax returns than others from the same gross return. All in, taxes can chew off 40 percent or more of pretax returns.

Lastly, inflation. Inflation isn't an explicit "cost," but it might as well be. Depending on the era, inflation usually bleeds away 2 percent to 6 percent of your purchasing power every year. Unlike the costs above, you "pay" for inflation regardless of what you invest in, even if you don't invest in anything (with the possible exception of inflation-protected bonds and, indirectly, stocks). With inflation, you are helpless. You can't run, you can't hide. You can't blame your financial adviser; you can only sob on his or her shoulder as your money drains away. You can't do anything but make more and save more and invest some of your portfolio in asset classes likely to beat inflation over the long haul.

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So what does this mean for our projected median return? Bearing in mind that costs, fees, taxes, and inflation vary, let's assume that, on average, each year, transaction costs consume 0.5 percent of assets; fees 1.0 percent of assets; taxes 20 percent of gains, income, dividends, etc.; and inflation 3.0 percent of assets.

On the brokerage firm's assumed median return of 9 percent, this would result in a pre-inflation net return of about 6 percent per year and a net increase in purchasing power of about 3 percent per year—less than the advertised rate, but nothing to sniff at. For every $10,000 invested today, I would have about $18,000 in 2014, or $13,000 in today's dollars. On my assumed median return of 4 percent, however, the pre-inflation return would only be about 2 percent per year, with a net loss of purchasing power of 1 percent a year. For every $10,000 invested, I would have about $12,000 in inflated dollars in 2014, or $9,000 in today's dollars. (Brokers, investment advisers, and the government, meanwhile, would have run off with about $2,200.)

Back-of-the-Envelope Real Returns *

The Impact of Costs and Inflation

CostBrokerage Firm EstimateMy EstimateGross Return9.0 percent4.0 percentLESS:Transaction Costs0.5 percent0.5 percentFees1.0 percent1.0 percentTaxes20.0 percent20.0 percentNet Return     6.0 percent2.0 percentInflation3.0 percent3.0 percentActual Return3.0 percent-1.0 percent

Lest this sound depressing, it's worth noting what would happen if I did nothing—if I just buried the $10,000 in the backyard. I wouldn't pay any costs, fees, or taxes (hallelujah!). Thanks to inflation, however, when I dug the money up again, it would be worth only $7,400.

Next week: What your financial adviser is good for (and what he/she probably isn't).