Mutual funds may be right for you -- but they're an expensive way to invest. If you have the slightest inclination to do it yourself -- and make a lot more money -- this might help.
I want what's coming to me!
With the possible exception of local property taxes, no mechanism I know picks our pockets more efficiently than the U.S. mutual fund industry. Yes, that includes the IRS.
Think about it. Uncle Sam takes a piece of everything you earn, and that's trifling. But your fund manager is worse. He's not content with a cut of what you earn each year. (We'll assume for now that he makes you money.) No, your fund manager wants more -- much more.
When I tell you how much more, you may not believe it. So I'll warm you up with a quick example.
Wahoo! My manager's a genius!
The year is 1990. The economy is stagnant, Saddam Hussein is rattling his saber, and President Bush assures us that "This will not stand." You just dumped 10 grand into the greatest mutual fund in the history of the world.
That's because your fund manager doesn't buy the gloom and doom, and he doesn't buy diversification. He buys technology. So, he rolls the dice on just four tech stocks.
You hit pay dirt! Now it's New Year's Day 2000, and just look at what's become of your $10,000 stake ...
- Cisco Systems (Nasdaq: CSCO ) : $1,673,750
- Applied Materials (Nasdaq: AMAT ) : $178,239
- Sun Microsystems (Nasdaq: JAVA ) : $158,689
- Qualcomm (Nasdaq: QCOM ) : $298,021
You could be sitting on $2.3 million! But mutual funds have a price, and it may be a lot higher than you think.
Your $10,000 isn't worth $2.3 million!
You see, assuming your fund manager hits you up for a 2% fee (not cheap, but hardly unheard of), you would owe him about $37,000. That seems fair enough. After all, the fellow just made you $2.3 million. But here's the catch.
That $37,000 is for the last year alone. You've actually been paying out every year along the way. In fact, by New Year's Day 2000, you'd have paid that rascal more like $70,000 in fees, and the lost profits on those fees would have cost you a lot more -- another $340,000 or so. And that's over 10 short years!
That's a high price, but it gets worse. Imagine if you'd invested $20,000 instead of $10,000. You'd be paying twice as much! And what do you get for all that extra money -- for paying twice as much? Not a darn thing, as far as I can tell.
Oh, yes, it gets worse still
Now, what if it turns out you're paying for nothing? I mean, let's face it, you're not going to buy into a miracle fund like the one I just described. Your manager won't be a genius. More likely, he'll be an Ivy League MBA looking to keep his job and follow the herd -- or worse.
Don't believe me? Look no further than the list of widely held institutional stocks. I'll spare you the trouble: You'll find Citigroup (NYSE: C ) and IBM (NYSE: IBM ) right near the top, alongside other usual suspects. Now, run down the top holdings in your mutual funds. See anything familiar?
Worse, even if your fund manager did stumble on a category-killer like Amgen or some other massive gainer, what are the chances he would actually hold on for the entire ride? More likely, he'd have bought and sold many times over. You guessed it: In addition to the outrageous annual fee, you'd have paid taxes and transaction costs!
There may be a better solution
Just this morning, I was looking over Mark Hulbert's latest audit of the nation's top investment newsletters. According to Hulbert Interactive, the stocks David and Tom Gardner have recommended to their Motley Fool Stock Advisor members have returned 20.02% annualized (better than twice the return of the S&P 500) since the newsletter's 2002 inception.
For the sake of argument, let's say you earned precisely that return for the next 20 years. If you managed to sock away just $1,000 a year, you'd wind up with $224,606. For that, you'd pay the broker commissions (say, $9 a trade) plus the cost of your annual subscription.
That might sound like a lot -- until you compare it with what you'd pay to own the same stocks in most mutual funds. In fact, all those expenses added up over 20 years would pale in relation to the $3,300 you'd pay your fund manager ... in the last year alone! All told, you'd hand over roughly $20,000 and forfeit another $40,000 in gains.
So you see why I love the IRS
After all, in any given year, the IRS can tax you only on what you earn. Your mutual fund manager takes a cut of everything you have ... year after year after year. In other words, even if you don't make a cent in Year 21 of our example, be prepared to hand over another $3,300.
For all that, it's just possible you have no interest whatsoever in buying, much less researching, your own investments -- even with the help of David and Tom Gardner and a newsletter service such as Stock Advisor. If so, mutual funds may be for you. It definitely beats staying out of the market, but you can agree it's a broken model.
Here's something else to consider
If you balk at buying a house in the Hamptons for some guy you've never met, try Stock Advisor free for 30 days instead. David and Tom can't guarantee you 20.02% every year -- or that they will always thump the S&P 500 by so much. But that's their explicit goal, and something 75% of mutual fund managers don't do.
Best of all, as your portfolio grows, your costs won't. It won't set you back two grand a year to join the $100,000 club ... or $120,000 a year to be the $6 million man (or woman). That should be your goal, after all -- a massive portfolio. And it's not one you should approach with mixed feelings.
To steal a phrase from that sour-faced know-it-all on the TD Ameritrade commercials, "You can do this." For a little help, give Stock Advisor a try. You can try it free, check out David and Tom's top recommendations for right now, and there's no obligation to join if you don't love it. To learn more click here.
This article was originally published on June 13, 2006. It has been updated.
Fool writer Paul Elliott doesn't own any of the stocks mentioned. You can see all of David and Tom Gardner's Stock Advisor recommendations immediately with your free trial. The Motley Fool has a disclosure policy.