Look, I know I was a little rough. And, yes, I bashed my friends in the mutual fund industry. Did I expect a few angry emails? Of course, but not this.
Feeling a little lost?
A few months back, I proposed a little experiment I thought you'd enjoy. It was a bogus mutual fund made up of just three stocks, each bought in January 1990 and sold 10 years later.
For my three stocks, I chose consumer electronics retailer Best Buy (NYSE: BBY ) and old-school technology outfits Texas Instruments (NYSE: TXN ) and Hewlett-Packard (NYSE: HPQ ) . But as you're about to see, any number of former highfliers could have done the trick.
The idea was to show how a modest $10,000 investment could have ballooned to $422,563 in just 10 short years. But that wasn't the surprising part. For more details, check out "Don't Invest Another Penny." Just be sure to come back, because this is where it gets good.
You see, there was a catch. Over the years, you'd have paid your mutual fund manager some $20,000 in fees, and surrendered nearly $58,000 in lost profits (money you could have earned on those fees, but didn't). Instead of $422,000, you'd be sitting on ... well, 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 three stocks, much less time the market so perfectly.
In other words, I thought you'd say that my $78,000 blood money was a gross exaggeration. I thought wrong.
Apparently, you're OK with me comparing the fund industry to an IRS on steroids. In fact, some of you think I'm understating the case -- trivializing the real cost to you as an investor, at least on a percentage basis.
And guess what? You're right. John Bogle, the founder of Vanguard Funds, makes the case bluntly in his book, The Battle for the Soul of Capitalism. Bogle shows how you don't need blowout returns (like in my three-stock example) to make the case against mutual funds ... you need time. Here's why.
Beware the "tyranny of compounding"
As it turns out, financial "intermediation" costs would have eaten up just 19% of your total returns ($78,000 out of $412,562) in my example. That sounded like a lot to me, but apparently not to Bogle -- nor to some of you, either. In fact, for most of us, it will be worse.
For one thing, you won't be making 4,126% every 10 years, like in my bogus example. That's because for every stock rocket like Yahoo! (Nasdaq: YHOO ) that your fund catches for a quick 10-bagger, it'll surf an E*TRADE (Nasdaq: ETFC ) for a 90% plunge (yes, I know it's coming back). But mostly, it'll bounce between IBM (NYSE: IBM ) and Pfizer (NYSE: PFE ) , and other widely held stocks.
And even when your fund manager does catch lightning in a bottle, he or she will buy and sell too often, and at the wrong times. That's why Vanguard's Bogle thinks you'll earn less than "average" -- 8.5% per year by his estimate. Plus, you won't invest for 10 years, but more likely 25, 30, or even 45 years or more. Brace yourself, because this thing really gets ugly.
That'll be 80% off the top, sir
According to Bogle, if you invest for 45 years at his expected market return of 8.5% per year, "intermediation" costs can steal as much as 80% of your rightful profits. You read that right. Not a mere 19%, like in my ridiculous little scenario, but as much as 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 doubles every 10 years or so, costs can really wipe you out.
What you can do about it
Frankly, I don't share Bogle's outlook for stocks. I think we'll do better from here, even after the rally no one saw coming. But even if we make three times as much as Bogle expects, we'll still fork 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. You don't have to jump in all at once, and you don't have to dump all your funds right away. But you can see how important it is that you give it some thought. Even so, you will need a few great stocks to get started -- and a little support.
Here's an easy solution. Give Motley Fool Stock Advisor a look. Every month, you get the two top recommendations from Motley Fool co-founders David and Tom Gardner, and it's free for 30 days. (In the spirit of full disclosure, Stock Advisor has returned 13.8% annually since inception, at time when the S&P 500 has been flat. I can hardly believe that number myself.)
Of course, there's no pressure to join -- and if you do decide to stay on after your trial, it sure as heck won't cost you $100,000. These are interesting times for investors. If you never considered checking Stock Advisor out -- and wondered what all the fuss is about -- now may be the time to find out. 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 Pfizer, which is an Inside Value recommendation. Best Buy is a Stock Advisor and Inside Value pick. Pfizer is an Inside Value recommendation. The Fool owns shares of Best Buy. You can view the entire Stock Advisor scorecard with your free trial. The Fool has a disclosure policy.