What Are Foregone Earnings?
Let me explain foregone earnings to you directly: they represent the difference between the earnings you actually achieve and what you could have earned without fees, expenses, or lost time dragging things down. A big chunk of this comes from the investment fees you pay, which can eat up a sizable portion of your potential returns.
The key assumption here is that if you faced lower fees, you'd automatically see better returns. This concept comes up a lot with sales charges, management fees, or the total expenses tied to funds.
Key Takeaways
- Foregone earnings are the difference between an investment's actual earnings and what could have been realized without fees.
- These earnings essentially reflect the capital spent on investment fees.
- The idea assumes that lower fees lead to better market returns for investors.
- Examples include sales charges and operating fees in mutual funds that create foregone earnings.
Understanding Foregone Earnings
When it comes to investment performance, foregone earnings can seriously hinder the long-term growth of your assets. You typically pay fees for access to mutual funds, ETFs, and other pooled investments. Mutual funds are actively managed, with a portfolio manager buying and selling securities, while ETFs are passive, often tracking indexes like the S&P 500, which means they usually have lower fees.
Even something as straightforward as a front-end load or a 1% management fee can add up to thousands over time due to compounding. You need to research the costs of each investment to keep foregone earnings in check.
Tip on Opportunity Cost
Remember, foregone earnings are a form of opportunity cost – that's the price you pay for missing out on a better option, effectively leaving money on the table.
Examples of Foregone Earnings: Mutual Funds
Let's look at mutual funds as a prime example. Sales charges can hit you hard as an investor. The Financial Industry Regulatory Authority (FINRA) outlines potential front-end load charges that might decrease based on how much you invest, through what's called breakpoint discounts.
Possible Breakpoint Discounts
- Investment Amount: Less than $25,000 – Sales Charge: 5.00%
- Investment Amount: At least $25,000 but less than $50,000 – Sales Charge: 4.25%
- Investment Amount: At least $50,000 but less than $100,000 – Sales Charge: 3.75%
- Investment Amount: At least $100,000 but less than $250,000 – Sales Charge: 3.25%
- Investment Amount: At least $250,000 but less than $500,000 – Sales Charge: 2.75%
- Investment Amount: At least $500,000 but less than $1,000,000 – Sales Charge: 2.00%
- Investment Amount: $1 million or more – Sales Charge: No sales charge
Types of Sales Charges
Sales charges pop up at different stages. They're commissions paid to distributors to compensate brokers. Front-end charges are a percentage of your initial investment, often with class A shares. Back-end charges apply when you sell, typically with B-shares. Deferred sales charges are back-end fees that decrease over time and might even go to zero if you hold long enough – these are contingent on your holding period.
If you're an individual investor, you often get lower fees through discount brokers, and many platforms skip sales charges entirely. You can also avoid them by investing directly with the fund company. Mutual funds set these charges for intermediary transactions, and some provide returns breakdowns with and without charges.
Take the ClearBridge Aggressive Growth Fund: as of August 31, 2022, its one-year return without sales charges was -25.33%, but with charges, it dropped to -29.62%. That 4.29% difference is pure foregone earnings. This shows why breakpoint discounts matter – they cut fees, letting more gains compound for better long-term results. Do your due diligence on a fund's breakpoints to see if you qualify and what it takes.
Fund Operating Costs
You also lose out on earnings from mutual fund operating fees, which cover management, distribution, transactions, and admin costs. Funds report gross and net expense ratios; a net ratio means there are waivers or reimbursements, but it often rises to the gross level once those expire.
Compare management fees and gross vs. net ratios to gauge foregone earnings. Passive funds usually have lower ratios than active ones, which need higher fees for management and trading. Suppose you invest $10,000: a 0.5% fee costs $50 yearly, while 2% costs $200. Choosing the higher fee means $150 in foregone earnings annually, assuming similar market exposure.
Redemption Fees
Mutual funds might charge redemption fees to discourage short-term trading, with timeframes from 30 days to over a year. These fees go back to the fund for costs. Steering clear of them helps cut down on foregone earnings.
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