Drip. Drip. Drip.

Do you hear that?

No, it’s not the old bathroom faucet driving you crazy by breaking the nighttime silence. If only it was that simple! One inexpensive gasket would fix that right up, but this is something much more insidious.

Drip. Drip. Drip.

It’s the sound of your portfolio leaking thousands of dollars a year.

Anyone who has purchased a mutual fund or ETF has inevitably dealt with the associated fees that pay for the fund’s operating expenses. That expense ratio is just how funds work, and even though there are a few new zero-fee options that cover their costs in other ways (nothing in finance is truly free), there’s generally no escaping them. While they may seem very small on the surface — typically measured in tens or hundredths of a percent — when applied to your portfolio they add up fast. So it’s critically important for any diligent money manager to account for those expenses when designing a financial plan.

The thing is, calculating the effect of expense ratios on a portfolio is actually a lot harder than it sounds. The ER is unique for every fund, fund options vary by market, and things like work retirement accounts are notorious for offering funds with inflated fees compared to similar options found elsewhere. Combine all that with additional costs like adviser fees, and people who write about asset allocation and portfolio theory face a pretty tough problem. How on earth do you account for the expenses involved in every portfolio you talk about when the expenses vary so much for each investor?

As a result, the majority of financial authors just punt and ignore expenses altogether while listing that assumption in the fine print. That certainly makes the calculations a lot easier, but the downside is that any averages, drawdowns, and withdrawal rates they provide are guaranteed to over-estimate the actual return that a real-world investor will experience. Some others assume a single average expense ratio for every investor, which at least acknowledges the presence of fees but may still be quite inaccurate based on your personal fund options. And there’s even a third group who habitually over-state the required expenses by including sky-high adviser fees and passing them off as totally normal. Does the slow drip bother you? How about a burst pipe flooding the entire house?

Expense ratios have historically been a tricky prospect for Portfolio Charts, as accurately tracking the true expenses for countless combinations of hundreds of index funds in dozens of countries is… well… really challenging. So for the most part I’ve stayed firmly in the first group and ignored expenses while encouraging people to account for them on their own. But the recent addition of the Fund Finder changed all that, and today I’m happy to announce the next step in that larger plan.

Portfolio Charts now fully accounts for the expense ratio of every portfolio!

## How it works

Check out any chart, and you’ll notice a new expense ratio input at the bottom-right corner of the asset allocation interface.

The default setting is “Auto”, which means that it will automatically calculate the best-case expense ratio for your chosen portfolio. It does this by scanning a database of index funds in your country, identifying the least expensive options for each asset, and weighting them based on your portfolio settings. Basically, it runs the Fund Finder and always reports the best available total expense ratio for your chosen portfolio.

To see how that works in real time, watch what happens when you move some of the low-cost TSM allocation to a more expensive commodities fund and then switch countries to the UK where there are more affordable commodities index options available. The expense ratio follows along with no extra effort required.

Behind the scenes, the tools use that expense ratio to adjust the annual returns for the portfolio just like they already do for inflation and exchange rates. So all of the charts will always show your true purchasing power after the required expenses.

Since the expense ratio functionality is built upon the foundation of the Fund Finder, the two features also play well together. So if you’re using the My Portfolio tool or any of the Portfolio pages, when the expense ratio is set to “Auto” then it will also account for any fund changes you make using the Fund Finder. That way, the data will always accurately account for the specific fees of your fund choices.

For those who want a little extra control, there’s also a dropdown option* where you can enter a custom expense ratio.

(*) There are a few comparison tools where the custom option isn’t available due to how the numbers are calculated, but all charts include the Auto option.

I’d recommend that most people just leave it on Auto and let the tools do all the work, but a custom ER could be handy for a few different situations. For example:

- Set it to zero to compare the numbers to other sources that ignore fees.
- Manually enter an ER to account for the costs of your own unique funds.
- Include an adviser fee to see how much it affects your long-term returns.
- Add the effect of a percentage-based wealth tax.

So no matter your situation, I’ve got you covered.

If you think the automatic expense ratio calculations are cool, take a moment to appreciate that it also extends to the Portfolio Finder. Unlike most tools that study one portfolio at a time or perhaps compare it to a short list of alternatives, The Portfolio Finder studies hundreds of options simultaneously. Rather than simply ignoring expenses or wrongly assuming that all asset allocations have the same expense ratio, every point on the chart has a different ER calculated for that specific portfolio. This evens the playing field and more accurately accounts for the cost tradeoffs with different investing decisions.

Long story short, all of the data on Portfolio Charts now reflects the real-world effects of expense ratios on portfolio performance. So no matter how you invest, the numbers should be that much more accurate and realistic.

## Interesting Observations

While automatically calculating and accounting for the unique expense ratio of any portfolio is a pretty neat technical trick, I can understand that in practical terms shaving a few tenths of a percent off of the final numbers might not sound like such a big deal. As long as you’ve been subtracting your own ER from the reported numbers all along, there should be no surprises, right? Well, like most financial rules of thumb the truth is more sophisticated than you might naturally believe.

Here are a few things to look for in the data that may surprise you.

#### It’s more than just subtraction

When talking about expense ratios, it’s normal to think of them as a fee that you simply subtract from the return every year. While that’s usually a pretty decent approximation, the underlying math doesn’t really work like that. For example, watch how the average real return of the Classic 60-40 portfolio changes when you increase the expense ratio from zero to 1.00 percent.

As you can see, a 1% ER lowered the average return by 1.1%. That’s not a mistake! The reason that happens is that the effect of expense ratios is not linear but geometric, which is just a fancy way to say that they compound with your portfolio as it changes value. The math for that is a little more complicated than simply subtracting the ER from the annual return, and in a growing portfolio the true impact will be a little larger than the ER in isolation.

#### Safe withdrawal rates are still safer than you think

Fees are a particular concern for retirees, as even low expense ratios can still represent a relatively large percentage of their total annual expenses. For example, someone spending 4% of their portfolio but paying a 0.5% expense ratio would need to allocate one out of every eight dollars of their planned expenses just for fund fees. But while the easy and conservative way to account for that is to subtract the expense ratio from the safe withdrawal rate, the real portfolio behavior is way more unintuitive than that.

Take a look at the safe withdrawal rates for the Coffeehouse Portfolio using increasingly higher expense ratios from 0-5%.

The 30-year SWR for this portfolio with no expense ratio was 5.2%. But surprisingly, every 1% increase in expenses lowered the SWR not by 1%, but by only 0.4-0.5%. In fact, even with an insanely high 5% fee that is about the same size as the default safe withdrawal rate with no fee, the resulting real-world SWR was still as high as 3%!

The reason for that really weird behavior is something that Michael Kitces wrote about nearly a decade ago that I finally have the data and tools to validate. For reference, Kitces cites two pieces of research (one his own, and another by Gordon Pye) that independently showed each 1% increase in the expense ratio reduced the safe withdrawal rate by only 0.4-0.5%. So clearly we’re all on the same page.

To summarize Kitces’s explanation for this phenomenon, fund expenses reduce in absolute cost along with the declining portfolio size as the safe withdrawal rate intentionally spends a portfolio down to zero. So using default SWR spending methodology, your withdrawals will stay at the original level and adjust up every year for inflation but the portfolio expenses inevitably shrink over time. The end result is that even though high expense ratios do tend to compress the spread of portfolio outcomes at the high end (look at the mass of blue lines above), the overall effect of the expense ratio on worst-case safe withdrawal rates is much less than you probably think.

While we’re at it, also take a look at the perpetual withdrawal rates on the same chart. While safe withdrawal rates for this portfolio only change by 0.4-0.5% with each 1% increase in expenses, the perpetual versions change by 0.7-0.8%. The reason for this is that PWRs are designed to maintain inflation-adjusted value over time rather than spend money down to zero. And the amount of fees paid in absolute dollars for a portfolio that maintains its value will be higher than for a portfolio that depletes its value.

#### Big adviser fees are a huge drag

Sometimes numbers have a way of obscuring what they truly measure. For example, it’s easy to fall into the trap of only thinking about portfolio fees in terms of tiny percentages. To fight that instinct, I’ve found that it helps to put them into real-life context. Sure, the financial adviser you’re considering may be quick to point out that his 1% fee is chump change relative to your overall net worth. But what if I told you that the true cost is way more painful than just a few extra dollars?

Below is the Financial Independence chart for a young Merriman Ultimate investor who plans to diligently save 25% of her income with the ultimate goal of retiring early. In one example, she manages her own money using low-cost index funds. In the other, she pays an adviser an additional 1% to manage the same portfolio for her. Focus on the best-case scenario of how long it took for a similar investor to reach her goal.

The next time you think about paying someone a high percentage-based annual fee to manage your money, stop for a moment to think beyond the raw number. Maybe you truly value professional assistance and can talk yourself into paying 1% of your portfolio every year. But are you willing to also hand over 3 years of your life? No matter whether you manage your own portfolio or seek a helping hand, the numbers suggest that a few short hours of searching for cheaper options can pay off in years towards your goals.

Your financial choices ultimately cost way more than just money. Choose wisely.

## Moving Beyond Assumptions

Of course, those few examples just scratch the surface of how fees and expenses affect portfolio performance, and there’s no way to cover them all at once. But clearly expenses are a big deal, and understanding how they affect your investments is an important step in making wise financial decisions.

In the spirit of helping in those decisions, I’m exited to be able to offer the new expense ratio feature built into every tool on the site. From Portfolio Growth in accumulation to Retirement Spending as you plan for a happy future, you can now account for expenses in every choice. And rather than simply discounting the average expense ratio off of every portfolio, it automatically calculates the precise expense ratio of *your* portfolio and allows you to tweak the numbers as needed. When planning for your life savings, realism matters.

So even though those realistic numbers are labor-intensive to calculate, keep in mind that there are people out there who are up to the challenge to make things easier. Don’t just ignore major things that affect your purchasing power — like inflation, exchange rates, and fees — or blindly follow the financial advice of others that did the same. The tools are all right at your fingertips to understand your portfolio beyond academic idealizations. Roll up your sleeves and start exploring!

That slow portfolio leak may never be completely avoidable, but with the right preparation you’ll confidently know exactly what to do.

Drip. Drip. Drip.

Let’s grab a wrench and fix this together.

Coffee is way cheaper than portfolio fees