You guys never cease to amaze me.
Was I a little rough? Yes. Did I blast the mutual fund industry for robbing us blind? Sure. Did I expect some hate mail? Of course, but not this.
How to lose $730 grand
Feeling a little lost? Here's a quick summary. A while back, I proposed a little experiment. Essentially, it was a bogus mutual fund made up of just four stocks, each bought in January 1990 and sold exactly 10 years later.
The idea was to show how your $10,000 investment in Cisco Systems (Nasdaq: CSCO ) , Applied Materials (Nasdaq: AMAT ) , Sun Microsystems (Nasdaq: JAVAD ) , and Qualcomm (Nasdaq: QCOM ) could have ballooned to more than $2.3 million in 10 short years. But there's a catch.
In those 10 short years, you'd have paid your mutual fund manager some $70,000 in fees, and surrendered nearly $341,000 in lost profits (capital gains not earned on those fees). Instead of $2.3 million, you'd be sitting on a lot less.
So, you hate me, right?
Of course you do, but for a different reason than I thought. I thought you'd take the funds' side. I thought you'd point out that nobody could pick just those four stocks, much less time the market so perfectly. In other words, that my $410,000 blood money is a gross exaggeration and unfair.
So you can imagine how amazed I was by what most of you really said. It'll amaze you, too. But first, let's revisit my second hypothetical -- namely, that you earned an impressive but more reasonable 22.8% per year. In this more realistic case, you'd still be out some $90,000 in fees and lost profits.
This second scenario assumes you invest $1,000 a year for 20 years. Your 22.8% return is the figure that industry watchdog Mark Hulbert says David and Tom Gardner have delivered annually to Motley Fool Stock Advisor subscribers since inception. For more details, check out "Don't Invest Another Penny." But please come back, because this is where it gets good.
You got worked like a chump!
Or so you told me. You even turned my personal hero, John Bogle, against me. Apparently, you don't mind me likening Wall Street to the IRS on steroids. No, you took me to task for understating the case -- for trivializing the real cost to you as an investor, at least on a percentage basis.
And you're right, Bogle makes the case bluntly in his latest book, The Battle for the Soul of Capitalism. Bogle makes it clear that you don't need outlandish returns (like in my super-stock '90s example) to make the case against mutual funds ... you need time. Here's why.
Beware the "Tyranny of Compounding"
As it turns out, the scourge Bogle calls financial "intermediation" costs would have eaten up just 17% of your total returns ($410,000 out of $2.3 million) in my outrageous example. That sounded like a lot to me, but apparently not to Bogle -- and not to some of you, either. In fact, for most of us, it will be worse.
For one thing, we won't be making 23,000% every 10 years, like in my earlier example. For every Apple (Nasdaq: AAPL ) your skipper catches for a 2,000% bounce off the bottom in April 2003, he'll clutch a Sirius Satellite Radio (Nasdaq: SIRI ) that never quite recovers. But mostly, we'll ride the usual widely held tigers like Chevron (NYSE: CVX ) -- if we're lucky, that is.
And even if your manager does catch a massive winner, he'll buy it and sell too often, and at the wrong times. That's one reason Bogle thinks you'll do even worse than "average" -- 8.5% per year by his estimate. Plus, you won't invest for 10 years, but more likely 25, 30, even 45 years or more. Think that's good news? Well, brace yourself, because this thing really gets ugly.
That'll be 80% off the top, sir
According to Bogle, if you invest for 45 years and get his expected market return of 8.5% per year, these dastardly "intermediation" costs can steal up to 80% of your rightful profits. You read that right, again. Not a mere 22% like in my little scenario, but up to a full 80%. Ouch.
For one thing, Bogle uses a more aggressive 2.5% for intermediation costs. Unlike me, he goes beyond reported "management fees" and includes taxes, transaction, and timing costs. And given that Bogle founded Vanguard, the most trusted mutual fund company in the world, I'm inclined to believe him.
More importantly, Bogle realizes that the more realistic your returns, the more deadly that 2.5% becomes, especially when compounded over the years. In other words, costs kill when your portfolio keeps doubling every six months, but when it's doubling every 10 years or so -- costs kill you dead!
What you can do about it
Frankly, I don't share Bogle's "realistic" outlook for stocks. I think we'll do better. But even if we go back to my assumption that you somehow manage the 22.8% per year that David and Tom Gardner's Stock Advisor members could have earned since the service started in 2002, you're still forking over well more than $100,000 in intermediation costs every 20 years.
If you sort of resent that, here's a solution a lot of folks are considering. Start managing your own investments. Of course, you don't have to jump in all at once, and you don't have to dump all your funds today. But you can see how important it is that you give it some thought soon.
Of course, you're going to need some great stocks, too. Give Stock Advisor some thought. You get a top pick each month from Motley Fool co-founders David and Tom Gardner, and you can try the whole service free for a whole month, with no obligation to subscribe. If you do decide to join after your trial, it sure as heck won't cost you $410,000. To learn more about this special free trial, click here.
This article was originally published on Sept. 29, 2006. It has been updated.
Paul Elliott does not own shares of any company mentioned in this article. You can see all of David and Tom Gardner's recommendations, including their top five picks for new money now, with your free trial. The Fool has a disclosure policy.