All right, I'm sorry. I take it back.
Yes, I guess I was a little rough. And, true, I bashed the mutual fund industry a bit. So I expected a little hate mail, but not this.
Feeling a little lost?
Don't worry -- here's a quick summary. In a column earlier this month, I proposed an experiment. It was a bogus mutual fund made up of just four stocks, each bought in January 1990 and sold exactly 10 years later.
I randomly chose Hewlett-Packard (NYSE: HPQ ) , Nortel Networks (NYSE: NT ) , Adobe Systems (Nasdaq: ADBE ) , and Motorola (NYSE: MOT ) for my fantasy fund. But any former -- or current -- highflier would have done the trick.
The idea was to show how a modest $10,000 investment could have ballooned to more than $135,000 in 10 short years. But there was a catch I wanted you to consider first.
In those 10 years, you'd have paid your mutual fund manager some $10,000 in fees, and surrendered nearly $25,000 more in lost profits (capital gains not earned on those fees). So instead of $135,000, you'd be sitting on a lot less.
So you hate me, right?
Of course you do, but I thought you'd take the funds' side. I thought you'd point out that nobody could pick just those four winning stocks, much less time the bull market so perfectly.
In other words, I thought you'd say that my $35,000 blood money is a gross exaggeration and unfair to your manager and the fund industry.
For more details and the surprising results of this little experiment, check out "Don't Invest Another Penny." But please come back, because this is where it gets good.
You got it all wrong!
Or so some of you told me. Apparently, most of you don't mind me comparing Wall Street to the Internal Revenue Service on steroids. Many who wrote in took me to task for understating the case -- for trivializing the real cost to you as an investor, at least on a percentage basis.
John Bogle -- the founder of Vanguard Funds, of all people -- agrees with you. He makes the case bluntly in his latest book, Enough. Bogle shows how it's not blowout returns (like in my superstock '90s example) that make the case against mutual funds ... it's time in the market. Here's why.
Beware the "Tyranny of Compounding"
As it turns out, what Bogle calls financial "intermediation" costs would have eaten up just 28% of your total returns ($35,000 out of $125,000) in my hypothetical fund. 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.
After all, we won't be making 1,250% every 10 years, as in my example. That's because for every Yahoo! (Nasdaq: YHOO ) your skipper catches for a one-year 600% ride in 1998, he or she'll clutch a Juniper Networks (Nasdaq: JNPR ) for a 60% plunge two years later. But mostly, he or she'll follow their buddies into the highly liquid usual suspects like Alcoa (NYSE: AA ) -- if we're lucky, that is.
And even if your manager does catch lightning, he or she'll likely jump in and out too often, and at the wrong times. That's one reason Bogle thinks you'll do worse than "average" -- 8.5% per year by his estimate. Plus, you won't invest for 10 years, but more likely 25, 30, even 45 years or more. Think that's good news? Well, brace yourself, because this thing really gets ugly.
That'll be 80% off the top
Bogle demonstrates how 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 rightful profits -- and that's at today's tax rates. You read that right, again. Not a mere 28% like in my ridiculous scenario, but up to a full 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 hurt when your portfolio keeps doubling every six months like in my example, but when it's doubling every 10 years or so -- costs kill.
What you can do about it
Frankly, I don't share Bogle's "realistic" outlook for stocks. I think we'll do a little better from here. But even if we make three times as much as Bogle expects, we'll be asked to fork over well more than $100,000 in intermediation costs every 20 years -- that's a lot of money.
If you sort of resent that, here's a solution a lot of folks are considering. First, get a hold of Bogle's book -- it really is fantastic. Then, consider 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. But you can see how important it is that you give it some thought soon.
Of course, you're going to need some stock ideas to get started. That's when I turn to my colleagues, Motley Fool co-founders David and Tom Gardner. They've given me a lot of help over the past seven years, and their recommendations are beating the market on average by more than 55 percentage points. If you like, you can check out their top picks for new money -- and their core portfolio holding -- right now.
And it's on me. Simply accept a special free trial to David and Tom Gardner's Motley Fool Stock Advisor newsletter. You can try the complete service free for a whole month -- and get their top picks and most valuable advice instantly. And if you do decide to join, it sure as heck won't cost you 80% of your rightful profits. To learn more about this special free trial, click here.
This article was originally published Sept. 29, 2006. It has been updated.
Paul Elliott does not own shares of any company mentioned. You can see all of David and Tom Gardner's recommendations instantly with your free trial. Adobe Systems is a Stock Advisor recommendation. The Fool has a disclosure policy.