Mutual funds may be OK for you. They beat sitting in cash ... but they're expensive, too. If you have the slightest inclination to "do it yourself" -- and make more money -- you should probably read this.
The richest guy in the room!
With the possible exception of local property taxes, nothing I've encountered picks our pockets more efficiently than the U.S. mutual fund industry. And yes, that includes the IRS.
How so? Well, Uncle Sam takes a piece of every penny we earn, and that's bad. But your typical fund manager isn't content with a cut of what your money earns each year (and we'll assume they actually make you money, unlike last year).
No, the guy who runs your mutual fund wants more -- much more. When I tell you how much more, you may be angry. So I'll warm you up with a quick example.
Woo-hoo! My manager's a genius!
The year is 1990. The economy is stagnant, Saddam Hussein is rattling his saber, and President Bush (the first one) assures us "this will not stand." You just dumped $10,000 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 or she doesn't buy diversification. Your manager buys technology, by rolling the dice on just three stocks: Microsoft (Nasdaq: MSFT ) , Dell (Nasdaq: DELL ) , and Oracle (Nasdaq: ORCL ) .
You hit paydirt! Now it's New Year's Day 2000, and just look at what's become of your $10,000 stake before expenses:
- Microsoft: $313,395
- Dell: $2,833,333
- Oracle: $155,611
You're sitting on $3.3 million, right? Wrong. Mutual funds have a price, and that price may be higher than you imagine.
Your $10,000 isn't worth $3.3 million!
You see, assuming your fund manager hits you up for a 2% fee -- not cheap, but hardly unheard of -- you would owe about $55,000. That seems fair enough. After all, he or she just made you $3.3 million. But there's a catch.
That $55,000 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 about $130,000 in fees, and the lost profits on those fees have cost you a lot more -- another $600,000 or so. And that's over 10 short years!
That's about $730,000 -- 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 of that extra money -- for paying twice as much? Not a darn thing, as far as I can tell.
It gets worse
Now, what if it turns out that you're paying for nothing? I mean, let's face it; you're not going to find a miracle fund like the one I just described. Your fund manager isn't a genius. More likely, your manager's an Ivy League M.B.A. wanting 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 guarantee you'll find at least two of the three we just discussed, plus General Electric (NYSE: GE ) , Intel (Nasdaq: INTC ) , and ExxonMobil (NYSE: XOM ) . Now, run down the top holdings in your mutual funds. See anything familiar?
Worse, even if your fund manager did stumble on a game-changer like Electronic Arts (Nasdaq: ERTS ) or some other 10-bagger, what are the chances your manager would hold on for the entire ride? More likely, your manager would have bought and sold it many times over. You guessed it: In addition to the outrageous annual fee, you'd have been murdered on taxes and transaction fees!
And it gets worse ...
In any given year, the IRS can tax you only on what you earn. Your mutual fund managers take 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), but 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.
OK, even after all we just discussed, you may have no interest whatsoever in buying your own investments -- 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 the market, but you can agree that it's a broken model.
Something better to consider
If you balk at buying a house in the Hamptons for somebody you don't even know, try Motley Fool Stock Advisor free for 30 days instead. David and Tom Gardner can't guarantee that they will always outperform the S&P 500, but they have over the past seven-plus years -- by more than 40 percentage points. Doing so is their sworn mission, and it's something 75% of mutual fund managers do not 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 -- and it isn't 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. It's free for 30 days, and there's no obligation. To learn more, click here now.
This article was originally published on June 13, 2006. It has been updated.
Fool contributor Paul Elliott doesn't own any of the stocks mentioned. Electronic Arts is a Motley Fool Stock Advisor recommendation. Dell, Intel, and Microsoft are Inside Value picks. The Fool owns shares of Intel as well as covered calls on Intel. You can see all of David and Tom's Stock Advisor picks instantly with your free trial. The Motley Fool has a disclosure policy that prefers Assateague to the Hamptons.