This Investment Will Sink Your Portfolio

Your portfolio is like a brand-new boat that, over time, will inevitably develop holes and rust. The bad news is that your boat can sink, and along with it goes your life savings. The good news is that those holes can be avoided.

How? Get out of mutual funds right now. Why? Because they're a terrible investment.

I know that sounds harsh, but keep reading, and I promise I'll offer an investing strategy that is much better than the one you're probably pursuing right now.

Let me explain
It's been well-documented that mutual funds have underperformed the general market over long periods of time. In fact, actively managed mutual funds typically return 1.5 to 2 percentage points less than the overall market. Many people are aware of this but continue to throw their money down the drain. Fortunately, Morningstar recently released a report that can add some much-needed clarity to the topic.

Morningstar tracks funds based on past performance and volatility and then assigns them a star rating, indicating which funds are superior. However, it just announced that lower costs and fees were a much better indicator of future success than its own rating system. Specifically, it found that between 2005 and 2010, in every single asset class, the least expensive funds produced higher returns than the most expensive funds.

The main reason? Funds charge management fees, marketing fees, and because they have extremely high turnover, they have higher trading fees as well. These expenses add up and slowly eat away at your wealth. Bill Houck, a certified financial planner at Modera Wealth Management, puts it best: "Study after study has shown that most managers can't justify the cost of the fund over time."

Still not convinced? Take a look at your average mutual fund -- the expense ratio (how much you pay to hold that fund per year) is probably at least 1%. That modest-looking fee can strip away more than 40% of your savings over a 60-year period. This type of investment will absolutely sink your portfolio, period.

Take two simple steps
First, if you're completely tied to the idea of investing in mutual funds, then avoid ones with high costs and invest only in funds that have expense ratios of less than 0.75%. Broad exchange-traded funds can easily give you the market exposure you need -- for instance, the Vanguard Total Stock Market ETF (FUND: VTI) provides wide stock coverage and has a paltry expense ratio of 0.07%. Internationally, take a look at the Schwab Emerging Markets Equity ETF (FUND: SCHE), which has a low fee of 0.25%.

I understand that there are plenty of investors who don't want to just sail along with the indexes -- you want to beat the market, not follow it! That's great, but what you need to do is invest in individual stocks instead of funds. Think this is too time-consuming, that all the volatility may keep you up at night, or that you don't trust particular companies? Nonsense!

Let's first look at one example that can easily exemplify the entire strategy of investing in funds versus their cheaper ETF counterparts. Say you're a value investor interested in finding some great stocks at cheap prices. Consider two options, an actively managed fund versus a low-cost ETF:

Source: Morningstar; figures are for stocks within each fund's portfolio.

Not that I have anything against the Oak Value Fund, but why would an investor put hard-earned dollars there when all the studies in the world have pointed to low fees as the best gauge of future performance? Additionally, the ETF has picked stocks with lower P/E and P/B ratios, and its portfolio also pays a higher dividend yield!

Let's take this one step further. You tell me that the Oak Value Fund has a chance at beating the market, and you're willing to pay up for that opportunity. As an avid investor, I understand the need and the urge to outperform an index or a passively managed ETF. Well then, I say, just invest in the individual components that make up the fund and avoid those high costs! Let's take a look at how that may actually work by listing seven of the biggest stocks in the Vanguard Value ETF and compare them to the traits of the Oak Value Fund.

Sources: Morningstar; Yahoo! Finance as of Aug. 14.

Simply put, you can buy these individual stocks at a cheaper price and obtain a higher dividend yield than if you bought the actively managed fund.

The Foolish bottom line
If you're a beginning investor or even an old sage, there's no better advice than to avoid high fees that never end up justifying themselves. Give yourself the best opportunity to obtain and build wealth over the long run by picking up cheap, quality stocks -- ones that pay dividends are just another reason to be content with your investment strategy. I guarantee that this philosophy is much better than sitting back and hoping for the best with your current mutual funds.

Do you disagree with me? Would you rather own an actively managed fund as opposed to seven excellent stocks? Let me hear it in the comments below!