Financial Fridays: Basis Points and Investing Fees
If you’re looking at investment solutions, you’re comparing offerings, service, and of course prices. But what does it mean when we say we charge 50 basis points?
Basis points, written as bps and often pronounced as ‘bips’, are a standard unit of measure for rates of change in investment products, and represent a ratio, like percentages. For example, the current federal interest rate is 2%, or 200 basis points. Like percentages, basis points are relative to the total amount they’re describing. And as you can see, they are really small: one basis point is just 0.01% of a total amount. With a large enough amount invested though, even changes of a few basis points can have a large impact. So what’s the point of basis points, if they’re so similar to percentages? Changes in an investment’s performance can be really minuscule, so sometimes it’s easier to understand in tens or hundreds of basis points instead of tenths or hundreds of a percent. And why learn about basis points? Well, fees for investment products (and returns, such as in some fixed income products) are often shown in basis points, so it’s important to be able to do the right calculations. An in-person financial advisor will usually charge at least 100 basis points (or 1%). Online options like robo advisors can get pretty low, but are usually between 30 to 75 basis points, plus whatever extra fees they charge. It can be easy to look at those numbers and think that there’s not much of a difference, but the more you invest – and the longer you invest – those basis points can start to add up. Let’s look at an example where you open an investment account with $1000, and you can do it with either a financial advisor who charges 100 basis points (1%) or a robo advisor (like OpenInvest) that charges 50 basis points (0.5%). When you start investing, 1% of $1000 isn’t much. What’s $10 a year? But because of how compound interest builds on prior growth, that 1% loss each year will slow and reduce your earnings in the future. Take a look at how your investment would grow at an average rate (historically, the market earns 8% returns each year, so we’ll go with a conservative 6%). Then see how your investment is affected by fees of 50 basis points and 100 basis points.*
As you can see, it takes a while for the differences in returns resulting from each fee structure to grow noticeably large. But then they get bigger much faster. If you started investing in your twenties with fees of 100 basis points, by the time you retired, you’d have lost over one third of your investment returns to fees. By contrast, if you’d paid only 50 basis points per year, you’d only have turned over a fifth of your earnings. While in a perfect world you’d get to keep all of your returns, you’d be hard pressed to find a financial advisor who will let you do that. Make sure you read all the details of any financial advisory service you’re exploring. More importantly keep an eye out for hidden fees and make sure you’re really comparing apples to apples. *6% is a conservative estimate of the average annual return of the stock market over the last century, adjusted for inflation. Historical performance is no guarantee of future performance.