Every percentage point paid as fee matters

There is a bug in the human brain owing to which it rushes to the conclusion that a fee of 1 per cent per annum (pa) over any number of years totals up to 1 per cent of the amount.

- AVINASH LUTHRIA

That is completely wrong. The brain struggles to understand that a fee of 1 per cent pa over 10 years becomes a total fee of about 10 per cent. Nobel Prizewinner William Sharpe correctly observed that minimising investment costs, along with diversification, are the two most important rules in investing. So, let us fix this bug.

The brain finds it comfortable to shut down when faced with too much complexity. To fix that, we have to simplify, even if that requires a small sacrifice in accuracy.

Suppose you have a corpus of ₹10 crore, kept in physical cash at home. You agree to pay the security guard a fee of 1 per cent p.a. In the first year, you pay a fee of ₹10 lakh, leaving you with ₹9.9 crore. In the second year, the fee is ₹9.9 lakh. The total fee over two years is ₹19.9 lakh. This total fee of ₹19.9 lakh divided by ₹10 crore is 1.99 per cent over two years. This is close to 2 per cent.