You guys never cease to amaze me.
Was I a little rough? Yes. Did I bash the mutual fund industry for robbing us blind? Sure. Did I expect some hate mail? Of course.
Feeling a little lost?
Don't worry -- here's a quick summary. In a recent column, I proposed an experiment: a bogus mutual fund made up of just three stocks, bought in January 1990 and sold exactly 10 years later.
For my portfolio, I chose three familiar large-cap techs, but any number of former highfliers could have done the trick:
- Microsoft (Nasdaq: MSFT)
- Dell (Nasdaq: DELL)
- Oracle (Nasdaq: ORCL)
The idea wasn't to show how a $10,000 investment could have ballooned to more than $3.3 million in 10 short years -- but rather, that there was a catch involved.
In those 10 years, you'd have paid your mutual fund manager nearly $130,000 in fees, 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 funds' side and point out that nobody could pick just those stocks, much less time the market so perfectly. I thought you'd tell me my $730,000 blood money was a gross, unfair exaggeration.
Just wait until you hear what most of you really said. But first, let's revisit my second hypothetical from back in December -- namely, that you invested just $1,000 a year for yourself for 20 years. In this case, you earned a slightly more reasonable, yet still impressive, 20.02% per year. Well, you'd be out just $8,000 in fees and lost profits.
And there's nothing random about this second scenario. That 20.02% return is what industry watchdog Mark Hulbert says David and Tom Gardner have delivered annually to their Motley Fool Stock Advisor subscribers, for more than five years now. For details, 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 OK 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 -- makes the case bluntly in his latest book, The Battle for the Soul of Capitalism. Bogle shows how you don't need blowout returns (like in my superstock '90s example) to make the case against most mutual funds ... you need time. Here's why.
Beware the "tyranny of compounding"
As it turns out, in my example, 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 to some of you, either. In fact, for most of us, it will be worse.
For one thing, we won't be making 30,000% every 10 years like in my example. That's because for every Corning (NYSE: GLW) your skipper catches for a 1,700% bounce off the bottom in October 2002, he'll clutch a CMGI (Nasdaq: CMGI) for a 98% plunge. If we're lucky, our guy will stick to the usual tigers like Johnson & Johnson (NYSE: JNJ), along with everybody else.
And even if your fund manager does stumble in front of a freight train like Research In Motion (Nasdaq: RIMM), he'll buy and sell it over and over -- and probably at the wrong times. Add it up, and Bogle thinks you'll do even worse than "average" -- 8.5% per year, by his estimate.
Finally, you won't invest for 10 years, but more likely 25, 30, even 45 years or more. Think at least that's good news? 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 dastardly "intermediation" costs can steal up to 80% of your rightful 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.
More importantly, Bogle realizes that the more "realistic" your returns, the bigger a bite that 2.5% per year becomes, especially when compounded over the years. In other words, costs kill when your portfolio keeps doubling every six months -- but when it's doubling every 10 years or so, costs kill you dead!
What you can do about it
Frankly, I think we'll do better with stocks than Bogle says. But even if we go back to my optimistic assumption that you can match the remarkable 20.02% per year Stock Advisor members could have earned over the past six nears, you're still forking over $8,000 in intermediation costs every 20 years.
If you sort of resent that, here's a solution a lot of folks are considering: Start managing some 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 giving it some thought could save you a lot of money.
Of course, it all starts with finding great stocks. Give Stock Advisor some thought. You get a top pick each month from Motley Fool co-founders David and Tom Gardner (remember, their picks have more than doubled the market average), and you can try the entire service free for a whole month.
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, click here.
This article was originally published Sept. 29, 2006. It has been updated.
Paul Elliott owns shares of Johnson & Johnson. Microsoft and Dell are Inside Value recommendations. Dell is a former Stock Advisor pick. Johnson & Johnson is an Income Investor pick. The Fool has a disclosure policy.
