Why 1% Matters

Why 1% Matters

The significance of one percent

Tell me if you’ve read something like this before:

  • By putting your money in X, you can make 1% more per year
  • ABC Fund charges 2% per year to look after your money, but XYZ only charges 1%.

Maybe you’ve run across statements like this before. Maybe you haven’t.

Either way, what was your reaction to reading them? Did you shrug, yawn and go back to your smartphone game? So did I when I first read them. I mean, saving 1% of something, so what?

Statements like these are thrown around a lot in financial literature, with authors assuming we know that 1% is important. The problem is that for most of us, high school math did a great job landing you with mathematical skills you may never use in your day job, and didn’t do a good job teaching us the skills we actually need in the real world.

Let’s break down why 1% is important in finance.

How do you use percentages?

I’m blowing some cobwebs off math memories here. Think back to when you were first taught about percentages.

It was probably in the context of something like: Q. Bill has a pizza he wants to share with his friend. He cuts the pizza in half. If Bill takes one half, how much of the pizza has he eaten? A. 50%. Boom, your first encounters with percentages use big numbers.

Now have a think about the percentage math you use in everyday life. Here are a couple of examples:

  • Your favourite clothes shop is having a 20% off sale today. You can buy that awesome outfit you were eyeing for $80 instead of $100. You just saved $20!
  • You use a smartphone app to work out the tip you’re paying at the restaurant for 10-25% of the bill.
  • You pay tax on 30% of every dollar you earn in that new job, so you will get paid 70% of your gross salary every month

We don’t sweat the small stuff

The percentages you use in everyday life will likely be large: 10%, 20%, 30%, 50%. Because of this, small percentages, like those stated in finance, seem really minor. Mentally, we calculate small percentages differently.

Here’s an example. Would you walk an extra few kilometres to buy a $100 item if you save 1% on the price and it’s $99? How about a 25% saving dropping the price to $75? I know I’d only walk extra to take the second saving.

So why do small percentages matter in finance?

Compounded change, large amounts, long timelines

Here’s the secret. Small percentages matter when the changes they introduce are compounded, when the amounts involved are large, and the timeframe is long. Let me show you what I mean.

Let’s say Ahmed has $10,000 he wants to invest. ABC Fund lets him invest it with them and after paying their fees, he’ll get 5% per year. He puts it in and doesn’t touch it for 10 years.

His friend Yolanda also has $10,000 to invest, but she goes with ZYX Fund, which has lower fees than ABC. As a result, she gets paid 6% per year. She also doesn’t touch the money for ten years.

You’ll notice this is the same situation except for the difference in fees of 1%. So who comes out ahead? I used this compound interest calculator to work it out. Ahmed comes out with $16,470 while Yolanda makes $18,194. Over this time frame, 1% results in over $2000 in different returns. That may not be a groundbreaking difference, but due to the power of compounding, 1% becomes much more significant than you might consider at first.

Let’s change a couple of features to show the significance to amounts and time. First, amounts. If Ahmed and Yolanda’s original investments were $100,000, there would be a difference of over $20,000 in their returns after 10 years ($164,700 and $181,940 respectively). Second, time. If we push the timeframe on the original amounts out to 20 years, Ahmed comes out with $27,126 and Yolanda with $33,102. Not a bad increase for the minor trouble of picking a fund with lower fees.

So while 1% may not seem like much for a short term purpose, it has powerful long term effects when it compounds.

Think for yourself!

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