Foregone Earnings

Investment earnings that could have been obtained if the investment required no fees or expenses

What are Foregone Earnings?

Foregone earnings are investment earnings that could have been obtained if the investment required no fees or expenses. They are potential investment costs incurred by an investor paying fees such as management fees for a mutual fund or exchange-traded fund (ETF) investment or commissions to a stock brokerage firm.

 

Foregone Earnings

 

The term “foregone earnings” is often used about investment fees to point out not only the investment capital lost to fees but also the additional return that capital might have generated.

Foregone earnings are also referenced in the context of employment. It usually refers to earnings foregone by choosing to attend a college or university full-time or by taking an extended period of time off from work – such as when a mother chooses to recuse herself from the workplace for a year or two to stay at home and take care of her children.

 

Summary

  • Foregone earnings describe investment earnings that could have been obtained if the investment required no fees or expenses.
  • The concept of foregone earnings is important because it points out the true cost to investors that investment fees represent.
  • Foregone earnings are also spoken of in the context of the cost of higher education or of taking extended time away from the workforce.

 

Significance of Foregone Earnings

Many investors do not realize the true impact on their potential investment returns that investment fees can have. Typical mutual fund sales or management fees of 1%-2% may appear relatively insignificant, but over the long term, they can have a substantial negative effect on your investment returns.

Assume that you invest $10,000 in a mutual fund that charges an annual management fee of 2%. It means that $200 would be deducted from your total investment capital each year. Now, assume that your mutual fund investment generates an average annual return of 8%.

At the end of 10 years, you will have paid $2,000 – 20% of your original investment – in management fees. But to calculate what those fees have really cost you, you must consider how much more money your investment could have earned if all the money that went to fees had instead been generating an 8% annual profit along with the rest of your investment capital.

In such a case, your potential lost additional profits add up to $1,560.88. The figure is calculated by figuring the total compound 8% interest on an initial $200 plus an additional $200 added each year for 10 years.

Therefore, the real total cost of the seemingly insignificant management fees over 10 years is not $2,000 but $3,560.88 ($2,000 + $1,560.88) in foregone earnings.

In fact, the true amount of foregone earnings would be even higher because your 8% annual return on your investment would increase the absolute dollar amount of the 2% management fee charged each year.

However, a constant annual management fee figure was used in this example.

Foregone earnings are pointed out so that investors may realize the full impact of all the fees and expenses that are commonly associated with investments and pay more attention to seeking out investment avenues that require the lowest investment costs.

 

Earnings Foregone through Education

As the cost of higher education has skyrocketed over the past couple of decades and as many students have found themselves burdened with staggering amounts of student loans, the concept of foregone earnings concerning the pursuit of a university degree has become more important.

Foregone earnings are, in this context, essentially an extra cost of higher education. They represent the income that an individual might have earned by being employed full-time for four years rather than spending that time pursuing higher education.

In short, the true cost of attending a university for four years to get a degree is not merely the university tuition and other associated costs, but that amount plus all the money that might have been earned during four years of full-time employment.

Of course, one must also consider the future greater earning potential that may be obtained by getting a university degree.

Foregone earnings are also referenced with entering the full-time workforce and taking an extended period of time off from work. In this context, you have to consider both lost wages and how the time off from work may impact your future earnings after you return to work.

For example, after taking a year or two out of the workforce, it may require two years of working when you return to obtain a promotion and raise that you might have gotten within one month had you stayed in the workforce.

 

More Resources

CFI is the official provider of the Certified Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.

In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

  • Exchange Traded Fund (ETF)
  • Brokerage
  • Continuing Education
  • Investment Methods

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