Every dollar counts when you’re saving for retirement or another big financial goal. That includes the dollars you’re paying in brokerage fees and losing to expense ratios – which can add up to a lot more than you realise, thanks to what’s called “negative compounding.”
Negative compounding is essentially the opposite of compounding. It represents the money you could have earned in compounding gains, but didn’t.
If you buy an expensive mutual fund, one that costs you around 1% of your balance per year in fees, that’s 1% of your entire retirement savings being subtracted each and every year.
It’s not 1% of your savings in that year or 1% of your gain. It’s 1% of everything you’ve ever saved and all the money that you’ve earned from compounding, taken from you.
Thus the effect of a 1% fee in a stock mutual fund is that you lose one-third and up to one-half of your potential gains to the fund’s managers. You’ve effectively sandbagged your own retirement.
This is another argument for why you should invest in low-cost index funds, but we can take it even further than that and apply the negative compounding ethos to any potential purchase.
That is: Would you rather have the item you’re about to buy, or all of the compounded gains that money might earn for you in the future?
Yes, there’s always some risk involved in investing. On the other hand, since the compound interest you’ll get from sticking that money in a savings account probably won’t beat inflation, the three bucks you’re thinking about putting towards a cup of coffee (why is it always coffee) will probably be worth less in the future than it’s worth right now unless you invest it.
On the third hand, don’t forget that buying stuff can add value to your life that comes with its own compound gains — the benefits of regularly visiting a coffee shop where you see people you know and feel integrated with your community, for example.
Still, if you’re trying to grow your net worth, save for retirement, pay down debt, sock away enough money for a down payment, and all of the other big financial goal stuff that usually gets listed here, thinking about how to avoid negative compounding is a smart move. This means:
Getting into investing, if you haven’t already (the earlier you start, the more your investments can compound)
Looking for low-fee or no-fee investments with low expense ratios (which means the majority of your money will stay in the investment)
And then… well, compounding takes time, so you might have to wait a while. But at least your money isn’t compounding in the wrong direction.