Look, I can't say for sure that mutual funds are wrong for you. They beat sitting in cash, after all, and they're fairly easy. But they're expensive, and there are performance issues to consider, too.
So if you have an inclination to "do it yourself" -- and maybe make more money and keep more of what you make -- you should probably read this just in case.
A bit of a racket
With the exception of local property taxes, nothing I've encountered in finance 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.
My fund manager's a genius!
The year is 1990. The economy is stagnant, Saddam Hussein is rattling his saber, and President George H.W. Bush 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. He doesn't buy diversification, either. Your manager buys technology and rolls 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. Wrong! Remember, 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 the guy 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 out 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.
All in, 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 won't be a genius. More likely, your manager's an Ivy League MBA wanting to keep his job and follow the herd -- or worse.
Don't believe me? Look at 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 he would have held on? More likely, you'd have been in and out 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 has kindly agreed to tax you only on what you earn. Your mutual fund manager takes 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 (after all, most do), 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 in fees.
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. Like I said, it 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, here's a better idea a lot of folks are considering. Why not start managing some of your own investments? You don't need to sell all your funds at once, and now you don't need to go it alone.
Each month, Motley Fool co-founders David and Tom Gardner handpick one investment idea and pass it along to their Motley Fool Stock Advisor subscribers. They can't guarantee their picks will outperform the S&P 500 every year, but they have over the past seven-plus years -- by more than 50 percentage points on average.
Best of all, if you decide to follow along and your portfolio grows year after year, your costs won't. Turning to David and Tom Gardner for help 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 Motley Fool Stock Advisor a try. If you click on the link below, you can even try the entire service free for 30 days, and there's no obligation to join. To learn more, click here now.
This article was originally published June 13, 2006. It has been updated.
Fool contributor Paul Elliott doesn't own any of the stocks mentioned. Intel and Microsoft are Motley Fool Inside Value selections. Electronic Arts is a Stock Advisor pick. The Fool owns shares of and has written puts on Oracle. Motley Fool Options has recommended buying calls on Intel and diagonal calls on Microsoft. 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.