After all these years, you guys still never cease to amaze me.
Was I a little rough? Yes. Did I bash the mutual fund industry for sticking it to us? Sure. Did I expect a little hate mail? Of course.
Are you 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, each bought in January 1990 and sold exactly 10 years later.
For my fund, I chose these three familiar large-cap techs, but any number of former highfliers could have done the trick:
The idea wasn't to show how a $10,000 investment could have ballooned to more than $3.3 million in 10 short years, which it did -- but rather, that there was a cost 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 have found Microsoft, Dell, and Oracle in 1990, much less timed the market so perfectly.
I thought you'd tell me that my $730,000 blood money was a gross exaggeration. Just wait until you hear what most of you really said. 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. Apparently, you're OK with my 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, who visited us recently here at Fool HQ -- 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 most mutual funds ... you need time. Here's why.
Beware the "tyranny of compounding"
As it turns out, in my "super fund" 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 not to some of you, either. In fact, for most of us, it will likely be much worse.
For one thing, we won't be making 30,000% every 10 years, like in my example. That's because for every Corning
And even if your fund manager does stumble in front of a freight train like Research In Motion
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 "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 predicts. But even if you make an almost-unheard-of 20% per year, you'll still fork over $80,000 in intermediation costs every 20 years. Not 85% of your profits, maybe, but that's real money.
If you sort of resent that, here's a solution that 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 right away. 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 and buying at the right time. I still believe that now is that time. As for the stocks, give Motley Fool Stock Advisor some thought. Each month you get a top pick straight from Motley Fool co-founders David and Tom Gardner, with the full case and any foreseeable risks spelled out.
Does it pay? It has so far. Over more than six years, their recommendations are beating the market by better than 39 percentage points. Best of all, you can sample the entire service free for a whole month right now.
And this much I can promise you: 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 and position yourself for the inevitable rally, 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. Johnson & Johnson is an Income Investor pick. You can view David and Tom Gardner’s entire scorecard with your free trial. The Fool has a disclosure policy.