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 should probably 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 reckoning includes the IRS.
Think about it. Uncle Sam takes a piece of every penny you earn, but your mutual fund manager is worse. He or she isn't content with his cut of what your money earns each year. (We'll assume for now that your fund actually makes you money.) 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 past 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 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, but I'm betting you'll find mostly old-school Altria (NYSE: MO ) and Johnson & Johnson (NYSE: JNJ ) , along with hot tech names like Apple (Nasdaq: AAPL ) , among the 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 stealth bomber such as 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!
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 your money in a mutual fund, your fund manager takes a cut of everything you have ... year after year after year.
Worse, your manager might not only 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.
Frankly, 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
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Best of all, as your portfolio grows, your costs won't. 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. Getting wealthy should be your goal, after all -- and it isn't one you should approach with mixed feelings.
Listen, there's still a lot of negativity out there. 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." And you don't have to do it alone. 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.
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 selection. The Motley Fool owns shares of Best Buy. The Motley Fool has a disclosure policy.