Perhaps now I've heard everything.
Was I a little rough? Yes. Did I bash the mutual fund industry? Sure. Did I expect hate mail? Of course, but not this.
Feeling a little lost?
Don't worry -- here's a quick summary. A few months back, I proposed an experiment. It was a bogus mutual fund made up of just four stocks, each bought in January 1990 and sold exactly 10 years later.
I chose Hewlett-Packard
The idea was to show how your modest $10,000 investment could have ballooned to more than $135,000 in 10 short years. But there's a catch.
In those 10 short years, you'd have paid your mutual fund manager some $10,000 in fees and surrendered nearly $25,000 more in lost profits (capital gains not earned on those fees). So instead of $135,000, you'd be sitting on a lot less.
So you hate me, right?
Of course you do, but I thought you'd take the funds' side. I thought you'd point out that nobody could pick just those four stocks, much less time the market so perfectly.
In other words, I thought you'd say that my $35,000 blood money is a gross exaggeration and unfair.
For more details on my little experiment, 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. Now, apparently, you don't mind me comparing Wall Street to the IRS on steroids. 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, of all people -- makes the case bluntly in his 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 mutual funds ... you need time. Here's why.
Beware the "Tyranny of Compounding"
As it turns out, the scourge Bogle calls financial "intermediation" costs would have eaten up just 28% of your total returns ($35,000 out of $125,000) in my outrageous example. 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 1,250% every 10 years, as in my example. That's because for every Yahoo!
And even if your manager does catch lightning, he'll buy and sell too often, and at the wrong times. That's one reason Bogle thinks you'll do worse than "average" -- 8.5% per year by his estimate. Plus, you won't invest for 10 years, but more likely 25, 30, even 45 years or more. Think that's good news? Well, 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 "intermediation" costs can steal up to 80% of your rightful profits. You read that right, again. Not a mere 28% like in my ridiculous little scenario, but up to a full 80%. Ouch.
For one thing, Bogle uses a more aggressive 2.5% for intermediation costs. That's because he goes beyond reported "management fees" and includes 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 more deadly that 2.5% 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 don't share Bogle's "realistic" outlook for stocks. I think we'll do better from here. But even if we make three times as much as Bogle expects, we'll fork over well more than $100,000 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 of your own investments. You don't have to jump in all at once, and you don't have to dump all your funds today. But you can see how important it is that you give it some thought soon.
Of course, in this market, you're going to need some great stock ideas and maybe a little guidance, too. That's when I turn to my colleagues, Motley Fool co-founders David and Tom Gardner. They've given me a lot of help over the years. If you like, you can get David and Tom's top picks for new money right now. And it's on me.
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This article was originally published on Sept. 29, 2006. It has been updated.
Paul Elliott does not own shares of any company mentioned. You can see all of David and Tom's recommendations instantly with your free trial. The Fool has a disclosure policy.
