All right, I take it back! I'm sorry.
Was I a little rough? Yes. Did I bash the mutual fund industry? Sure. Did I expect hate mail? Of course. But not this.
Feeling a little lost?
Don't worry -- here's a quick summary. In a column last month, I proposed an experiment. It was a bogus mutual fund made up of just four stocks, each bought in January 1990 and sold exactly 10 years later.
I randomly chose Hewlett-Packard (NYSE: HPQ), Nortel Networks (NYSE: NT), Adobe Systems (Nasdaq: ADBE), and Motorola (NYSE: MOT) for my fantasy fund. But any number of former highfliers would have done the trick.
The idea was to show how your modest $10,000 investment could have ballooned to more than $135,000 in 10 short years. But there was a catch I wanted you to consider.
In those 10 years, you'd have paid your mutual fund manager some $10,000 in fees, and surrendered nearly $25,000 more in lost profits (capital gains not earned on those fees). So instead of $135,000, you'd be sitting on a lot less.
So you hate me, right?
Of course you do, but I thought you'd take the funds' side. I thought you'd point out that nobody could pick just those four stocks, much less time the market so perfectly.
In other words, I thought you'd say that my $35,000 blood money is a gross exaggeration and unfair to your manager and the fund industry.
For more details and the surprising results of this little experiment, check out "Don't Invest Another Penny." But please come back, because this is where it gets good.
You got worked like a chump!
Or so you told me. Apparently, you don't mind me comparing Wall Street to the IRS on steroids. Many of you who wrote in took me to task for understating the case -- for trivializing the real cost to you as an investor, at least on a percentage basis.
And you're right. John Bogle -- the founder of Vanguard Funds, of all people -- makes the case bluntly in his new book Enough. Bogle shows it's not blowout returns (like in my superstock '90s example) that make the case against mutual funds ... it's time. Here's why.
Beware the "Tyranny of Compounding"
As it turns out, the scourge Bogle calls financial "intermediation" costs would have eaten up just 28% of your total returns ($35,000 out of $125,000) in my hypothetical fund. That sounded like a lot to me, but apparently not to Bogle -- and to some of you, either. In fact, for most of us, it will be worse.
After all, we won't be making 1,250% every 10 years, as in my example. That's because for every Yahoo! (Nasdaq: YHOO) your skipper catches for a one-year 600% ride in 1998, he'll clutch a Juniper Networks (Nasdaq: JNPR) for a 60% plunge. But mostly, we'll ride the usual tigers like Alcoa (NYSE: AA) -- if we're lucky, that is.
And even if your manager does catch lightning, he'll buy and sell too often, and at the wrong times. That's one reason Bogle thinks you'll do worse than "average" -- 8.5% per year by his estimate. Plus, you won't invest for 10 years, but more likely 25, 30, even 45 years or more. Think that's good news? Well, brace yourself, because this thing really gets ugly.
That'll be 80% off the top
Bogle demonstrates how if you invest for 45 years at his expected market return of 8.5% per year, these "intermediation" costs can steal up to 80% of your rightful profits. You read that right, again. Not a mere 28% like in my ridiculous scenario, but up to a full 80%. Ouch.
For one thing, Bogle uses a more aggressive 2.5% for intermediation costs. That's because he goes beyond reported "management fees" and includes taxes, transactions, and timing costs. And given that Bogle founded Vanguard, the most trusted mutual fund company in the world, I'm inclined to believe him.
More importantly, Bogle realizes that the more "realistic" your returns, the more deadly that 2.5% becomes, especially when compounded over the years. In other words, costs kill when your portfolio keeps doubling every six months, but when it's doubling every 10 years or so -- costs kill you dead!
What you can do about it
Frankly, I don't share Bogle's "realistic" outlook for stocks. I think we'll do a little better from here. But even if we make three times as much as Bogle expects, we'll fork over well more than $100,000 in intermediation costs every 20 years.
If you sort of resent that, here's a solution a lot of folks are considering. First, get a hold of Bogle's book – it really is fantastic. Then, start managing some of your own investments. You don't have to jump in all at once, and you don't have to dump all your funds. But you can see how important it is that you give it some thought soon.
Of course, you're going to need some stock ideas. That's when I turn to my colleagues, Motley Fool co-founders David and Tom Gardner. They've given me a lot of help over the last seven years, and their recommendations are beating the market by more than 40 percentage points. I'd like you to check out their top picks for new money – and their core portfolio -- right now.
And it's on me. Simply accept a special free trial to David and Tom Gardner's Motley Fool Stock Advisor newsletter. You can try the complete service free for a whole month -- and get their top picks and most valuable advice instantly. And if you do decide to join (of course, there's no pressure), it sure as heck won't cost you $100,000 a year. To learn more about this special free trial, click here.
This article was originally published Sept. 29, 2006. It has been updated.
Paul Elliott
does not own shares of any company mentioned. You can see all of David and Tom's recommendations instantly with your free trial. The Fool has a disclosure policy.
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