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Stingy Investor Tip Sheet

Unwanted Partners

You're likely to have several sneaky partners who want a slice of your investment pie. Watch out because they might eat your profits.

When you buy funds you'll be charged an annual percentage fee based on the amount of money you have invested. This fee is called a management expense ratio or MER.

The taxman also wants his share. He'll take a cut of your profits if you don't hide them in a tax-advantaged account like a RRSP or a TFSA.

The government also eats away at your wealth by printing too much money. Inflation is the culprit here and it's the primary reason why ice cream cones which once cost $0.50 now cost $5.00. Inflation reduces your purchasing power and it can be quite insidious.

I created three graphs to highlight the impact that these partners can have on stock returns. Each has a line that matches the raw return generated by the S&P/TSX composite. (I used annual return data to make the graphs.) I then plot another line that tracks the index less fund fees. Here I assume the fund manger doesn't add any value and lags the index by the fees charged. The next line down tracks the index less fees and less capital gains taxes. The tax is applied annually which implies that the fund manager trades fairly frequently. The lowest line adjusts returns for fees, taxes, and inflation. Each graphs highlights a different fee and tax mix.

The first graph assumes a 2.5% annual fund fee (not uncommon for active Canadian equity funds) and a 20% capital gains tax. In this scenario you'd have only gained 23% after fees, taxes, and inflation since starting in 1970.

The second graph assumes a 0.25% fund fee (roughly the fee charged by Canadian exchange-traded funds) and a 20% capital gains tax. In this scenario you'd have more than doubled your money since 1970 after your partners' took their cut.

The third graph assumes a 0.25% fund fee and 5% capital gains taxes. In this scenario you'd have roughly quadrupled your money after fees, taxes, and inflation. If you hid out in a RRSP (i.e. 0% capital gains tax) then you'd have almost quintupled your money since 1970 after fees and inflation.

The moral of the story? Try to keep your partners' sticky hands off your cash. (But don't forget that special someone this Valentine's day.)

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02/05/2009   10:00 PM EST   Permlink   save & shareFees

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