Mutual funds may be right for you, but they're expensive. 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!
No mechanism I've encountered 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 the first President Bush assures us this won't stand. And you just dumped 10 grand into a mutual fund.
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! Fast-forward to 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 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 2001, 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? Not a darn thing, as far as I can tell.
Oh, yes, it gets worse
Now, what if it turns out you're paying for nothing? I mean, let's face it -- you're not going to buy a miracle fund like the one I just described. Your fund manager won't be a genius. More likely, he'll be some 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 and traded institutional stocks. I'll spare you the trouble: You'll find 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. In addition to the outrageous annual management fee, you'd have gotten murdered on taxes and transaction costs. But for now, let's focus on the fees.
No wonder the IRS wants in
In any given year, the IRS taxes you only on what you earn that year. Your mutual fund manager doesn't take a cut of everything you earn but everything you have ... year after year after year, regardless of whether he actually adds value.
Worse, your manager might not only fail to keep pace with the market in any given year (remember, most don't keep up), he might actually lose you money. Yet, even if you don't make a penny in year 21 of our previous example, you'll still have to hand over another few thousand dollars.
OK, 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 help from someone you can trust. 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, here's another solution. Accept a 30-day free trial to Motley Fool co-founders David and Tom Gardner's Motley Fool Stock Advisor.
Unlike most mutual fund managers, David and Tom have beaten the market since they launched Stock Advisor back in 2002. And while they can't guarantee their hot streak will continue, that's their stated 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 getting started, give Stock Advisor a try. It's free for a whole month, there's no obligation to join, and you get David and Tom's top picks for new money right now. To start your trial or simply learn more, 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 Blizzard 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.