Was I a little rough? Yes. Did I bash the mutual fund industry for bleeding us dry? Sure. Did I expect a little hate mail in return? Of course.
Are you feeling a little lost?
Don't worry -- here's a quick summary. In a previous column, I proposed what I thought was a reasonable experiment. It was a bogus mutual fund made up of just three stocks, each bought in January 1990 and sold exactly 10 years later.
For my fund, I chose these three familiar large-cap techs, but any number of former highfliers could have done the trick. I picked ...
The idea wasn't to show how a $10,000 investment could have ballooned to more than $3.3 million in 10 short years, which it did -- but rather, that there was a cost involved.
Amazingly, in those 10 years alone, you'd have paid your mutual fund manager nearly $130,000 in fees for his or her time and surrendered nearly $600,000 in lost profits (money not earned on those fees). So, instead of $3.3 million, you'd be sitting on a lot less.
So, you hate me, right?
Of course you do, but not for the reason I expected. I thought you'd take the fund industry's side and point out that nobody could have known to buy Microsoft, Dell, and Oracle in 1990, much less timed the market so perfectly.
I thought you'd tell me that my $730,000 price tag was a gross exaggeration. Just wait until you hear what most of you really said. For more details on my bogus mutual fund 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're fine with me comparing the U.S. fund industry to an IRS on steroids. Most of 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, who visited us here at Fool HQ -- makes the case bluntly. In his book The Battle for the Soul of Capitalism, Bogle shows how you don't need blowout returns to make the case against most mutual funds ... you need time. Here's why.
Beware the "tyranny of compounding"
In my "super fund" example above, financial "intermediation" costs would have eaten up just 22% of your total returns ($730,000 out of $3.3 million). That sounded like a lot to me, but apparently not to Bogle -- and not to some of you, either. In fact, for most of us, it will likely be much worse.
For one thing, we won't be making 30,000% every 10 years. That's because for every Corning (NYSE: GLW ) your manager catches for a 600% bounce off the bottom in October 2002, he or she will clutch a CMGI -- now cryptically called ModusLink (Nasdaq: MLNK ) -- for a 90% plunge. More likely, we'll hook up with what's called a "closet indexer" and wind up with a portfolio of usual suspects like Wells Fargo (NYSE: WFC ) .
And even if your fund manager does stumble in front of a freight train like Research In Motion (Nasdaq: RIMM ) , he or she will buy and sell it over and over -- and probably at the wrong times. Add it up, and Bogle thinks your mutual funds will do worse than the historical "average" -- 8.5% per year, by his estimate.
Finally, and most important, you won't invest for 10 years, but more likely 25, 30, even 45 years or more. Well, at least that's good news, right? Well, sort of -- but 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 "intermediation" costs can steal up to 80% of your profits. You read that right. Not 22% like in my scenario, but up to 80%. Ouch.
For one thing, Bogle uses a more aggressive 2.5% for intermediation costs, including not only reported management fees, but also 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 here's the catch: The more "realistic" your returns, the bigger a bite that 2.5% per year takes out of your hard-earned profits, especially when compounded over the years. In other words, costs hurt when your portfolio keeps doubling every six months -- but when it's doubling every 10 years or so, costs kill!
What you can do about it
I think we can do better than Bogle predicts, especially if we buy the right stocks. In fact, I've seen it. Over the past seven years, Motley Fool co-founders David and Tom Gardner have earned their Motley Fool Stock Advisor members 12.6% annualized -- at a time when the S&P 500 eked out a paltry 1.5% gain.
And I know for a fact we can keep our costs low. Frankly, why anybody would pay out 2.5% of their assets per year is beyond me. If you agree, here'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 all your funds right away. But you can see how giving it some thought could save you a lot of money.
Of course, it all starts with finding great stocks and buying at the right time. I still believe that now is that time. As for the stocks, give David and Tom Gardner's Motley Fool Stock Advisor some thought. Each month you get two top picks with the full case and any foreseeable risks spelled out.
Best of all, you can sample the entire service free for 30 days right now. And this much I can promise you: If you do decide to join after your trial, it sure as heck won't cost you $730,000. To learn more about this special free trial and position yourself for the inevitable rally, click here.
This article was originally published Sept. 29, 2006. It has been updated.
Paul Elliott owns shares of none of the companies mentioned here. Microsoft is a Motley Fool Inside Value selection. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Oracle. You can view David and Tom Gardner's entire scorecard with your free trial. The Fool has a disclosure policy.