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You guys never cease to amaze me.
Was I a little rough? Yes. Did I bash the mutual fund industry for picking our pockets? Sure. Did I expect some hate mail? Of course.
Feeling a little lost?
Don't worry -- here's a quick summary. A while back, I proposed an experiment. It was essentially bogus mutual fund I concocted out of just four stocks, each bought in January 1991 and sold in January 2000.
For my bogus portfolio, I chose these four stocks, but 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 nearly $300,000 in 10 short years. But that wasn't the amazing part. For more details, check out this column: "Don't Invest Another Penny." But come back, because this is where it gets good.
You see, there was a catch. In those 10 short years, you'd have paid your mutual fund manager nearly $20,000 in fees and surrendered nearly $50,000 in lost profits (money not earned on those fees). So instead of $300,000, you'd be sitting on a lot less.
So, you hate me, right?
Of course you do, but I thought you'd take the fund company’s side. I thought you'd point out that nobody could pick just those stocks, much less time the market so perfectly.
In other words, I thought you'd say that the $70,000 blood money in my example was a gross exaggeration. Just wait until you hear what you really said.
You’ve got it all wrong!
Or so you told me. Apparently, you're fine with me comparing the fund industry to an IRS on steroids. You took me to task for understating the case -- for underestimating the real cost to you as an investor.
And 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 that 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, financial "intermediation" costs would have eaten up just 23% of your total returns ($70,000 out of $300,000) in my hypothetical example. 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.
For one thing, you won't be making 2,900% every 10 years. That's because for every 10-bagger like Symantec (Nasdaq: SYMC ) your fund manager digs up, he'll bite on a Krispy Kreme (NYSE: KKD ) or Sprint Nextel (NYSE: S ) , or some other over-hyped story stock. But mostly, he'll keep you bouncing between JPMorgan Chase (NYSE: JPM ) and the other financials, and the rest of the most widely held stocks.
And even when your manager does catch lightning, he'll probably buy and sell too often, and at the wrong times. That's one reason 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. Well, 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, these dastardly "intermediation" costs can steal up to 80% of your rightful profits. You read that right. Not a mere 23% like in my hypothetical fund, but up to 80%.
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 lukewarm outlook for stocks. I think we'll do better from here, even after the recent bounce off the bottom. But 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 resent that, there's a solution a lot of folks are considering: Start managing some of your own investments. You don’t have to jump in all at once, and you don't have to dump your funds right away. But you can see how important it is that you give it some thought, right?
Of course, you will need a few great stocks to get started -- and maybe a little support. Here's something else to consider: Sign up for a free trial of Motley Fool Stock Advisor. Every month, you get useful investment advice plus the two top recommendations straight from Motley Fool co-founders David and Tom Gardner. It's free for 30 days, there's no pressure to buy anything, and if you do decide to join after your trial, it sure as heck won't cost you $100,000.
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This article was originally published Sept. 29, 2006. It has been updated.