The drag that compounds against you

One percent a year.

It is the most successful number in finance, and the reason is that it is quoted against the wrong thing. One percent sounds like a rounding error against a return of seven. It is not charged on the return. It is charged on everything you have, every year, including the parts that were charged last year and the year before.

Find the number

Move the fee and watch the share of the outcome that goes elsewhere. The gross return, the balance and the period are held still; the only thing changing is the annual charge.

Fee drag

≈ Hypothetical model, not a forecast

Compares a balance charged an annual percentage fee against the same balance charged nothing.

It assumes

• The gross return before charges is exactly the same in every one of the thirty years.
• The fee is a percentage of the whole balance, taken once at each year end.
• The percentage charged never changes across the entire period.
• Nothing is added to or taken out of the balance at any point.

It ignores

• Transaction costs, spreads and the cost of holding cash
• Tax, which can interact with fees in either direction
• Any fee charged as a flat amount rather than a percentage
• Whether the fee buys anything of value in return

Hold the return at 7% and the period at thirty years. Find the annual fee at which roughly a third of the no-fee outcome is given up — a share between 0.32 and 0.35.

Return before fees7%

Annual fee1%

Charged on the whole balance each year, not on the gain.

Final balance, after fees

563,079

Final balance, no fee

761,226

Fees handed over

83,557

How much smaller the balance ended up

198,147

Growth lost on top of the fees

114,589

Share of the no-fee balance given up

0.26

• No fee
• After the fee

◷ Not there yet — keep moving the controls.

Somewhere around one and a third percent a year removes about a third of the outcome over thirty years. Not a third of the growth. A third of the whole final amount, against the version with no charge at all.

Now look at the two figures the model reports separately: the fees handed over, and the growth lost on top of them. The second is larger than the first over long periods, and it is the part nobody is billed for. Every unit taken in year three is also not earning for the following twenty-seven years, and that missing growth belongs on the invoice as much as the fee does.

Predict

Two charging structures over thirty years: a flat fee of 1% a year, or a fee of 20% of the gains each year. Assume a steady 7% gross return. Which costs more?

Choose one answer

The 1% flat fee — it is charged whether or not there are gainsThe 20% of gains — it works out to about 1.4% of the balance a yearThey are equivalent by constructionIt depends on the balance

Lock in answer

Tax, which is the same arithmetic wearing different clothes

A tax charged on gains as they are realised behaves almost exactly like a fee. If the rate is a fifth and the return is 7%, then realising every year costs about 1.4% of the balance annually — the same drag as the fee in the question above, arriving from a different direction.

Set the fee in the model to 1.4 and you are looking at a reasonable approximation of it.

That gives the mechanism that actually matters, and it is not the rate. It is when the charge lands.

A gain that is not realised is not taxed yet, and the amount not yet paid continues to compound for you. Over decades that deferral is worth a great deal, and it means two identical portfolios with identical returns can end up substantially apart purely because one of them was traded frequently and the other was left alone. The one that traded paid its tax early, in instalments, losing the compounding on each instalment.

This is the single largest reason turnover is expensive, and it sits on top of the transaction costs that turnover also incurs.

What a fee is meant to buy

Being fair about this matters, because the arithmetic above can be read as an argument that all charges are theft, and that is not what it says.

A charge buys something: administration, custody, a structure, access to something otherwise unavailable, or somebody's judgement. Some of those are genuinely worth paying for, and a service that is worth 1% a year is worth 1% a year regardless of how large the compounded figure looks.

The useful question is therefore not whether the fee is small, but whether it is small relative to what it buys — and whether what it buys is available more cheaply elsewhere. The arithmetic in this lesson does not answer that. It tells you the size of the thing you are deciding about, which is normally much larger than the way it was quoted to you.

Check

Somebody compares two arrangements and says the difference between them is only half a percent a year. Over thirty years at a 7% gross return, what does that difference amount to?

Choose one answer

About one and a half percent of the final balanceRoughly a seventh of the final balanceAbout fifteen percent of the growthIt depends on the return, so nothing can be said

Check answer

Worth remembering

• A fee is charged on the whole balance while the return is earned on the same balance, so the two belong in the same unit.
• Over about thirty years at a 7% gross return, a fee near one and a third percent removes roughly a third of the final outcome.
• The growth lost because the fee was taken exceeds the fees themselves over long periods.
• Charges quoted against gains convert to a larger share of the balance, so every charge should be restated in one unit before comparing.
• Tax on realised gains behaves like a fee, and the timing matters more than the rate because deferred tax keeps compounding for the holder.