Mutual funds may be the thing for you, but they're an expensive way to invest. So, if you have the slightest inclination to "do it yourself" -- and make a lot more money -- you should read this.
I just want what's coming to me!
With the exception of local property taxes, no mechanism I've encountered picks your pocket 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 each year, but your mutual fund manager is worse. He isn't happy with his cut of what your money earns. (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 story I invented for just such an occasion.
Wahoo! My fund manager's a genius!
The year is 1990. The economy is stagnant, Saddam Hussein is rattling his saber, and President Bush assures us, "This will not stand." And you, the dummy that you are, just dumped 10 grand into a mutual fund.
But don't worry, your fund manager doesn't buy the gloom and doom. And he doesn't buy diversification, either. No, your guy buys technology. So he rolls the dice on just four tech stocks.
You hit paydirt! Now it's New Year's Day 2000, and just look at what's become of your $10,000 stake ...
- Hewlett-Packard (NYSE: HPQ ) : $25,625
- Nortel Networks (NYSE: NT ) : $45,736
- Adobe Systems (Nasdaq: ADBE ) : $37,254
- Motorola (NYSE: MOT ) : $26,215
Happy New Year! You're sitting on $135,000! But wait. Mutual funds have a price -- maybe a lot more than you think.
Surprise! You don't have $135,000
Assuming your fund manager hits you up for a 2% annual fee (not cheap, but hardly unheard of), you owe him roughly $2,250. That seems fair enough. After all, the fellow just made you $135,000. But there's a catch.
That $2,250 you just paid is for the last year alone. You've been paying out every year along the way. By New Year's Day 2000, you'd have paid the rascal nearly $10,000 in fees, and the lost profits on those fees would have cost you $25,000. And that's just 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 much, as far as I can tell.
Oh, yes, it gets worse still
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 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 the list of widely held institutional stocks. I'll spare you the trouble: You'll find Merck (NYSE: MRK ) and Altria (NYSE: MO ) in the mix, alongside a few dozen other usual suspects. Now, run down the top holdings in your mutual funds. See anything familiar?
Worse yet, even if your fund manager does stumble on a category-killer like medical device maker Medtronic (NYSE: MDT ) , or any other multibagger, what are the chances he'll have the guts to hang on for the entire ride? More likely, he will buy and sell many times over.
You guessed it: In addition to the outrageous annual fee, you get murdered on taxes and transaction costs.
And it gets worse ...
Because here's the thing. In any given year, the IRS can tax you only on what you earn that year. When you invest in a mutual fund, your fund manager takes a cut of everything you have ... year after year after year.
Worse, your manager not only might fail to keep pace with the market in any given year (remember, most do), he or she might actually lose you money. Yet, even if you don't make a penny in year 11 of our previous example, you'll still have to hand over another few thousand dollars.
That bites. Yet, for all that, you may have no interest whatsoever in researching stocks -- even with the help of someone you can trust. If so, mutual funds may be the only game in town. It definitely beats staying out of stocks over the long haul, but you can agree that it's a broken model.
Something better to consider
If you want to take advantage of the bargains in today's markets, but balk at buying a house in the Hamptons for somebody you don't even know, try David and Tom Gardner's Motley Fool Stock Advisor free for 30 days. The Motley Fool co-founders can't guarantee that they will always outperform the S&P 500, but that's what they have done over the past six-plus years.
And that's their sworn mission, something 75% of mutual fund managers do not do. Best of all, as your portfolio grows, your costs won't. Joining David and Tom at Stock Advisor 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 -- and it isn't one you should approach with mixed feelings.
We've been through a tough time together. It's only natural to feel uneasy, but this is no time to give up on stocks for the long-term. 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. To learn more, click here now.
This article was originally published June 13, 2006. It has been updated.
Paul Elliott does not own shares of any company mentioned. Of course, you can see all of David and Tom's Stock Advisor recommendations instantly with your free trial. The Motley Fool has a disclosure policy.