Mutual funds may be OK 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 -- you'd better read this.
I just want what's coming to me!
With the possible exception of local property taxes, no mechanism I've encountered picks our pockets more efficiently than the U.S. mutual fund industry. And yes, that includes the IRS.
Think about it. Uncle Sam takes a piece of every penny you earn, but your mutual fund manager is worse. He isn't content with his cut of what your money earns each year (we'll assume for now that he actually 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 fund manager's a genius!
The year is 1991. The economy is stagnant, Saddam Hussein is rattling his saber, and President Bush assures us that this aggression will not stand. And you just dumped 10 grand into a mutual fund.
Fortunately, your fund manager doesn't buy the gloom and doom, and he doesn't buy diversification, either. He buys good old American capitalism. So he rolls the dice on just three growth stocks.
You hit paydirt! Now it's New Year's Day 2000, and just look at what's become of your $10,000 stake ...
- Best Buy (NYSE: BBY ) : $275,333
- Texas Instruments (NYSE: TXN ) : $111,245
- Hewlett-Packard (NYSE: HPQ ) : $35,985
Happy New Year! You're sitting on $422,563! But wait. Mutual funds have a price. Maybe a lot more than you think.
Surprise! Your $10,000 isn't worth $422,563
You see, assuming your fund manager hits you up for a 2% fee (not cheap, but hardly unheard of), you would owe him about $8,000. That seems fair enough. After all, the fellow just made you $400,000. But there's a catch.
That $8,000 is for the last year alone. You've been paying out every year along the way. In fact, by New Year's Day 2000, you'd have paid that rascal more like $20,000 in fees, and the lost profits on those fees would have cost you a lot more -- another $58,000 or so. And that's over 10 short years!
That's about $65,000 and 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
What if it turns out you're paying for very little? I mean, let's face it -- you're not going to buy into a miracle fund like the one I just described. Your fund 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? Check out a list of the most widely held stocks. I'll spare you the trouble: You'll find the occasional surprise like Apple (Nasdaq: AAPL ) , but most are usual suspects, like Verizon (NYSE: VZ ) and Johnson & Johnson (NYSE: JNJ ) . Now, run down the top holdings in your mutual funds. See anything familiar?
Worse, even if your fund manager did stumble on a stealth bomber like Intuit (Nasdaq: INTU ) , or any other 10-bagger for that matter, what are the chances he'd actually hold on for the entire ride? More likely, he would buy and sell it many times over. You guessed it: In addition to the outrageous annual fee, you'd have gotten murdered on taxes and transaction costs!
There may be a better solution
Just this morning, I was looking over Mark Hulbert's latest audit of the results for some 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 (three times better than 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 approximately $320,000. For that, you'd pay the broker commissions (say, $10 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 a mutual fund. In fact, all of those expenses added up over 20 years (about $8,000) would pale in relation to the more than $80,000 you'd cough up in fees and lost profits.
So you see why the IRS wants in
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 previous example, be prepared to hand over another few thousand.
Still, it's possible that you have no interest whatsoever in buying, much less researching, your own investments -- even with the help of a newsletter service such as Stock Advisor. If so, mutual funds may be the only game in town. It definitely beats staying out of the market, but you can agree it's a broken model.
Here's something to at least consider
If you balk at buying a house in the Hamptons for some guy you don't even know, 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 it's 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). 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. It's free to try for a full month, you can see all of David and Tom's recommendations, and there's no obligation to join. To start your trial, click here.
This article was originally published June 13, 2006. It has been updated.
Fool writer Paul Elliott owns shares of Johnson & Johnson, a Motley Fool Income Investor choice. Best Buy is a Stock Advisor as well as an Inside Value pick. Apple is a Stock Advisor recommendation. You can see all of David and Tom's top picks plus read all the back issues instantly with your free trial. The Motley Fool has a disclosure policy.