Mutual funds may be just the thing for you. Then again, they can be obscenely expensive. So, if you have even the slightest interest in a simple alternative -- not to mention more money -- you might want to read this.
I want what's coming to me!
With the exception of local property taxes, 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 satisfied 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 show you how much more, you may not believe it, so let's warm up with a quick example. Step back with me to 1991 ...
Wahoo! My fund manager's a genius!
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. Good times.
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 ...
(Nasdaq: AMGN): $48,909
(NYSE: DNA): $26,348
(Nasdaq: SCHW): $192,344
(Nasdaq: ERIC): $37,101
Happy New Year to you! 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 out 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 won’t find a lot of surprises -- mainly just a lot of Comcasts
Worse, even if your manager did stumble on a stealth bomber like game developer Activision
Most mutual funds turn over their entire portfolios every year. So, 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.
And it gets worse ...
Because here's the thing. In any given year, the IRS can tax you only on what you earn that year. When you invest your money in a mutual fund, your fund manager takes a cut of everything you have ... year after year after year.
Worse, your manager might not only fail to keep pace with the market in any given year (remember, most do), he or she might actually lose you money. Yet, even if you don't make a penny in year 11 of our previous example, you'll still have to hand over another few thousand dollars.
If you ask me, that bites. Yet for all that, you may still have no interest in researching stocks -- even with the help of someone you can trust. If so, mutual funds may be the only game in town. It definitely beats staying out of stocks over the long haul, but you can agree that it's a broken model.
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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 Motley Fool Stock Advisor picks. Pfizer is an Inside Value choice. You can see all of David and Tom's Stock Advisor recommendations, including Charles Schwab and Activision, on their scorecard instantly with your free trial. The Motley Fool has a disclosure policy.