Mutual funds may be the thing for you, but they're an expensive way to invest. If you have even the slightest inclination to "do it yourself" -- and make a lot more money -- you'd better read this.
I just want what's coming to me!
With the possible exception of local property taxes, no mechanism known to man picks your pocket more efficiently than the U.S. mutual fund industry. And yes, that includes the IRS.
Think about it. Uncle Sam takes a piece of every penny you earn, but your mutual fund manager is worse. He isn't happy with his cut of what your money earns each year (we'll assume for now that he actually makes you money). No, your fund manager wants more -- much more.
When I tell you how much more, you may not believe it, so I'll warm you up with a quick example.
Wahoo! My fund manager's a genius!
The year is 1990. The economy is stagnant, Saddam Hussein is rattling his saber, and President Bush assures us, "This will not stand." And you just dumped 10 grand into the greatest mutual fund in the history of the world.
That's because your fund manager doesn't buy the gloom and doom, and he doesn't buy diversification. He buys technology. So, he rolls the dice on just four tech stocks.
You hit paydirt! Now it's New Year's Day 2000, and just look at what's become of your $10,000 stake ...
- Hewlett-Packard (NYSE:HPQ): $25,625
- Nortel Networks (NYSE:NT): $45,701
- Adobe Systems (NASDAQ:ADBE): $37,254
- Motorola (NYSE:MOT): $26,220
Happy New Year! You could be sitting on $135,000! But mutual funds have a price -- maybe a lot more than you think.
Surprise! Your $10,000 isn't worth $135,000
Assuming your fund manager hits you up for a 2% fee (not cheap, but hardly unheard of), you would owe him roughly $2,250. That seems fair enough. After all, the fellow just made you $135,000. But there's a catch.
That $2,250 is for the last year alone. You've been paying out every year. In fact, by New Year's Day 2000, you'd have paid that rascal nearly $10,000 in fees, and the lost profits on those fees would have cost you $25,000. And that's just over 10 short years!
That's 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 that extra money -- for paying twice as much? Not a darn thing, as far as I can tell.
Oh, yes, it gets worse still
Now, what if it turns out you're paying for nothing? I mean, let's face it, you're not going to buy into a miracle fund like the one I just described. Your fund manager won't be a genius. More likely, he'll be an Ivy League MBA looking to keep his job and follow the herd -- or worse.
Don't believe me? Look no further than the list of widely held institutional stocks. I'll spare you the trouble: You'll find Merck (NYSE:MRK) and Altria (NYSE:MO) right near the top, alongside other usual suspects. Now, run down the top holdings in your mutual funds. See anything familiar?
Worse yet, even if your fund manager does stumble on a category-killer like medical device maker Medtronic (NYSE:MDT), or any other 10-bagger for that matter, what are the chances he will actually hold on for the entire ride? More likely he will buy and sell many times over. You guessed it: In addition to the outrageous annual fee, you get murdered on taxes and transaction costs!
There may be a better solution
Just this morning, I was looking over Mark Hulbert's independent review of the results of the nation's top investment newsletters. According to Hulbert Interactive, the stocks David and Tom Gardner have recommended to their Motley Fool Stock Advisor members have returned 22.8% annualized (three times better than the S&P 500) since the newsletter's 2002 inception.
For the sake of argument, let's say you earned precisely that return for the next 20 years. If you managed to sock away just $1,000 a year, you'd wind up with approximately $320,000. For that, you'd pay the broker commissions (say, $9.99 a trade), plus the cost of your annual subscription.
That might sound like a lot -- until you compare it with what you'd pay to own the same stocks in a mutual fund. In fact, all those expenses added up over 20 years (about $8,000) would pale in relation to the more than $20,000 you'd pay your fund manager (who charges the average 1.5% expense ratio) -- and you'd forfeit $70,000 in gains.
So, you see why the IRS is jealous
After all, in any given year, the IRS can tax you only on what you earn. Your fund manager takes a cut of everything you have ... year after year after year. In other words, even if you don't make a cent in year 21 of our previous example, be prepared to hand over another few thousand.
For all that, it's possible you have no interest whatsoever in researching your own investments -- even with the help of a service such as David and Tom Gardner's Stock Advisor. If so, mutual funds may be the only game in town. It definitely beats staying out of the market, but you can agree it's a broken model.
Here's something to at least consider
If you balk at buying some guy you don't know a house in the Hamptons, try Stock Advisor free for 30 days instead. David and Tom can't guarantee you 22.8% every year -- or that they will always thump the S&P 500 by so much. But that's their explicit goal, and something 75% of mutual fund managers don't do.
Best of all, as your portfolio grows, your costs stay flat. It 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). Getting wealthy should be your goal, after all -- and it's not something 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 David and Tom a try. You get Stock Advisor free for 30 days, and there's no shakedown or obligation to join. To learn more about your free trial, click here.
This article was originally published June 13, 2006. It has been updated.
Fool writer Paul Elliott does not own shares of any company mentioned. Of course, you can see all of David and Tom's Stock Advisor recommendations instantly with your free trial. The Motley Fool has a disclosure policy.
