Mutual funds may be right for you, but they're an expensive way to invest. So, if you have the slightest inclination to do it yourself -- and make more money -- you might want to read this.
I want what's coming to me!
With the exception of local property taxes, no mechanism known to man picks our pockets 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's not content with his cut of what your money earns each year (we'll assume for now that he makes you money). No, your fund manager wants more -- much more.
When I tell you how much more, you may not believe it, so let's warm up with a quick example.
Wahoo! My fund manager's a genius!
The year is 1991. The economy is stagnant, Saddam Hussein is rattling his saber, and President Bush assures us this won't stand. And you just dumped 10 grand into a mutual fund.
Fortunately, your fund manager doesn't buy the gloom and doom, and he doesn't buy diversification, either. He buys technology. So he rolls the dice on just four up-and-coming growth stocks.
You hit paydirt! Now it's New Year's Day 2001, and just look at what's become of your $10,000 stake ...
Happy New Year! You're sitting on about $304,000! But wait. Mutual funds have a price. It may be a lot higher than you think.
Surprise! Your $10,000 isn't worth $304,000
You see, assuming your fund manager hits you up for a 2% fee (not cheap, but hardly unheard of), you would owe him about $6,000. That seems fair enough. After all, the fellow just made you $304,000. But there's a catch.
That $6,000 is for the last year alone. You've been paying out every year along the way. In fact, by New Year's Day 2000, you'd have paid that rascal more like $17,000 in fees, and the lost profits on those fees would have cost you a lot more -- another $50,000 or so. And that's over 10 short years!
All told, that's about $50,000 you've paid out, 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 very little? 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? Check out a list of the most widely held institutional stocks. I'll spare you the trouble: You'll find comeback-kid moneymakers like Halliburton
Worse, even if your manager did stumble on a stealth bomber like game developer Activision
More likely, he bought and sold it many times over. You guessed it: In addition to the outrageous annual fee, you'd have gotten murdered on taxes and transaction costs.
There may be a better solution
Just this morning, I was looking over Mark Hulbert's latest review of some 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 inception in 2002.
I can't promise they'll maintain that torrid pace, but 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 broker commissions (say, $10 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 of 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 wants in
After all, in any given year, the IRS can tax you only on what you earn that year. Your mutual fund manager takes a cut of everything you have ... year after year after year. In other words, even if you don't make a penny in year 21 of our previous example, be prepared to hand over another few thousand.
Even after all we've discussed, it's possible that you have no interest whatsoever in buying, much less researching, your own investments -- even with the help of a newsletter service such as Stock Advisor. If so, mutual funds may be right for you. It definitely beats staying out of the market, but you can see it's a flawed model.
Here's something else to consider
If you balk at buying a house in the Hamptons for some guy you've never met, 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 goal, and it's something 75% of mutual fund managers don't do.
Best of all, as your portfolio grows, your costs won't. 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). 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 Stock Advisor a try. It's free, there's no obligation to join, and you get David and Tom's top picks for new money right now. To start your trial, click here.
This article was originally published June 13, 2006. It has been updated.
Fool writer Paul Elliott doesn't own any of the stocks mentioned. Schwab and Activision are Stock Advisor picks. You can see all David and Tom's Stock Advisor recommendations on their scorecard instantly with your free trial. The Motley Fool has a disclosure policy.