Sunday, August 11, 2019

Friction Is Not Your Friend

Friction is not your friend.

Most people understand friction to be defined as the following.

I am talking about financial friction. That friction is defined this way by Investopedia.

Friction cost is the total direct and indirect costs associated with the execution of a financial transaction. The friction cost comprehensively takes into consideration all of the costs associated with a transaction. Calculating the friction cost provides an investor with a full range of expected costs they can expect to incur.

It is hard to become wealthy if you don't understand and appreciate friction costs. I am applying the concept of friction costs more broadly here than you might find in a textbook on finance. However, I think it is useful to think about friction costs as they might apply in some of the more common financial decisions an individual makes.

My experience is that most people do not pay enough attention to the friction costs in common financial decisions they make like buying a car, a house, investing in rental real estate or in their 401(k) plan.

Take the simple case of purchasing a personal vehicle. Sales taxes alone will add a fairly large sum to the final purchase price. That is friction. That is one of the reasons that I drive my cars for 10 years or more. Gasoline, insurance and repairs while you own the vehicle are also friction costs. That is why you should understand the "total cost to own" of any vehicle you are thinking of purchasing. Both Edmunds. com and Kelley Blue Book provide this information on their web sites.

Buying or selling a house brings a lot of friction costs. Real estate commissions, title insurance, transfer taxes and other closing costs are examples of these costs. That is why I generally tell young people to be certain of your situation before you buy a house. It is hard to overcome the friction costs in real estate if you are only going to stay in the house for a few years. Don't buy if you think you might want to move or the house will not meet your requirements in a few years. Rent and avoid the friction costs.

Friction costs also come into play during the time you own a house. Real estate taxes, insurance, HOA fees, maintenance, repairs. All of these costs gnaw, grind and wear away the actual return you will eventually receive from the "investment" in your house.

My experience is also that these friction costs are also easily forgotten when you calculate your return on an investment. You buy a house for $300,000 and sell it ten years later for $400,000. It is easy to think you made $100,000. Of course, the purchase and sales price don't take account of the transaction costs when you bought and sold the house. You don't think about the new carpeting and roof you replaced, the exterior painting you did, the hot water heater you replaced or the $1,000 you spent annually to have someone cut the grass while you lived there. Did you really make $100,000 on the house?

The same thing occurs when you buy rental investment property. There are a lot of friction costs and these might also include the time you spend between renters when you have no rental cash flow as well as your time in managing the property and your labor involved in any maintenance or repair issues. There is a reason it is called sweat equity and we often don't include these as friction costs.

The annual fees on the funds in your 401(k) or IRA are also friction costs. Pay attention to the amount you are paying to those who are managing your money. You don't consider those costs very closely if your portfolio is up 20% for the year. It seems a small price to pay. However, how will you feel if your portfolio is down 20% and the fees make it 21%?

You don't know for certain whether your investment will be up or down during the year. The only thing that is certain are the fees you will pay to manage that investment. Understand that and pay attention to these friction costs.

Friction costs add up. You may think you are only talking about pennies on the dollar. However, those pennies on the dollar add up.

You understand this when you see what a penny's difference can make when it is compounded over time.

Take the example of a graduating college student who receives a $2,000 gift at graduation from her grandparents. Her grandparents tell her to invest it in a retirement account and to add $2,000 to the fund each year for the next 45 years as a tribute to them. She does just that.

That money, compounded monthly at an 8% annual return, will give her almost $1 million at age 67. However, if she only earns 7% (a mere penny on the dollar less per year), she accumulates only $682,000. If she earns 9%, her retirement nest egg becomes $1,356,475.

An extra 1% in extra investment return per year makes a huge difference over a lifetime. That additional penny provides a lot of grease to assist in making your wealth wheel turn faster.

On the other hand, an extra 1% in friction costs to pay for higher investment management or advisor fees slows down that wealth wheel and erodes your return on that investment.

Those fees can be well worth the money if Warren Buffett is picking stocks for you or managing your investments. However, the fact is that only 19% of active investment fund managers around the world are doing better than their benchmark index according to a study by Bank of America.  Beware of active fund managers who are charging premium fees even though they may be delivering sub-par returns.

Remember that friction is not your friend when it comes to money.

See to it that your pennies do not get ground, gnawed or worn away by friction costs.

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