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Why fees matter: negative compounding and the tyranny of small percentages

Fees don’t just reduce returns—they reduce the base

A recurring fee (like an expense ratio, advisory fee, or platform fee) typically comes out every year. That does two things:

  1. It lowers your return this year.
  2. It lowers the amount you have invested, so you earn less every future year.

That second part is the kicker: fees compound against you.

Net return is what compounds

If your investments earn 7% but you pay 1% in ongoing fees, you don’t “lose 1% once.” You compound at roughly 6% instead of 7%.

A 1% annual fee isn’t 1% of your final wealth—it’s 1% every year of a base that could have been larger.

Not all fees are equally harmful

  • One-time fees (e.g., a single transaction cost) hurt, but they don’t keep repeating.
  • Ongoing percentage fees (charged annually on assets) are usually the most damaging over long horizons.
  • Performance fees can be complex; they may align incentives, but can still be expensive if the structure is rich.

An investor expects 7% annual market returns for decades. They switch to a product charging a 1% annual assets-under-management fee. Which explanation best captures why the long-run impact can be large?

Many people naturally think ‘it’s just 1%’ and treat it like a small one-time haircut. The real mechanism is that an ongoing percentage fee reduces your effective return every year, and the gap between compounding at 7% vs. 6% widens with time. The idea that it mostly matters early ignores that the fee keeps repeating. Volatility isn’t the core issue here; fees can hurt even if returns are smooth. And many common fees are charged on assets regardless of whether the year was profitable, which directly shrinks the compounding base.

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