Was I a little rough? Yes. Did I bash the mutual fund industry for robbing us blind? Sure. Did I expect some hate mail? I guess.
Don't worry -- here's a quick summary. In a recent column I proposed an experiment. Essentially, it was a bogus mutual fund made up of four stocks, each bought in 1992 and sold eight years later.
I chose EMC (NYSE: EMC ) , Clear Channel (NYSE: CCO ) , Xilinx (Nasdaq: XLNX ) , and AOL, which is now part of Time Warner (NYSE: TWX ) . But any number of former Wall Street darlings could have done the trick.
The idea was to show how a modest $10,000 investment could have ballooned to more than $2.4 million in eight short years. But there was a catch.
In those eight years, you'd have paid your mutual fund manager about $85,000 in fees and surrendered nearly $300,000 more in lost profits (capital gains not earned on those fees). So, instead of $2.4 million, you'd be sitting on a lot less.
So you hate me, right?
Of course you do, but I thought you'd take Wall Street's side in this. 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 $385,000 blood money – the management fees and lost profits sucked out of your account -- was a gross exaggeration, wholly unrealistic, and unfair.
For more details, 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 didn't mind my comparing Wall Street to the IRS on steroids. You 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 in his new book, Enough! Bogle shows how you don't need blowout returns (like in my superstock '90s example) to make the case against mutual funds ... you need time. Here's why.
Beware the "tyranny of compounding"
As it turns out, what Bogle calls financial "intermediation" costs would have eaten just 16% of your total returns ($385,000 out of $2.4 million) in my super fund example. That sounded like a lot to me, but apparently not to John Bogle -- or to some others. In fact, for most of us, it could be worse.
For one thing, we won't be making 5,900% every eight years, as in my example. That's because chances are that for every IPO your fund manager catches for a quick pop, the manager will surf a Crocs (Nasdaq: CROX ) for a death-defying plunge. But mostly, you'll ride the likes of Alcoa (NYSE: AA ) and Johnson & Johnson (NYSE: JNJ ) , right along with the rest of the widely held list.
And even if your fund manager does catch lightning, he or she will likely get cute, jumping in and out too often and at the wrong times. That's why Bogle says you'll do worse than "average" -- 8.5% per year by his estimate. Plus, you won't invest for just eight years, but more likely 25, 30, or even 45 years or more. Think that's good news? Well, brace yourself.
That'll be 80% off the top, sir
According to Bogle, if you invest for 45 years at his expected return of 8.5% per year, these "intermediation" costs can steal up to 80% of your rightful profits. You read that right. Not a mere 16% like in my ridiculous little 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.
And this is crucial: Bogle points out 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 outlook for stocks. I think we'll do better from here, despite the recent run-up. But even if we make three times as much as Bogle expects, we'll be forking over well more than $100,000 in intermediation costs every 20 years.
If you resent that, here's a solution a lot of folks are considering: Start managing your own investments. Of course, you don't have to dump all your funds right away. But you can see how important it is that you give this some thought -- and soon. Of course, you will need a few great stock ideas to get started.
For that, give Motley Fool Stock Advisor a try. You get top picks from Motley Fool co-founders David and Tom Gardner (there are no promises, but their picks are up on average 50% over the past seven years). And it's free for 30 days. There's no pressure to join -- and if you do decide to join after your trial, it sure as heck won't cost you $100,000. To learn more about this special free trial, click here.
This article was originally published Sept. 29, 2006. It has been updated.
Paul Elliott owns shares of Johnson & Johnson, a Motley Fool Income Investor recommendation. You can see all of David and Tom Gardner's recommendations instantly with your free trial. The Fool has a disclosure policy.