Mutual funds may be right for you. They’re certainly easy, and they give you quick and painless diversification. Best of all, you can usually set up an automatic investment plan that helps keep you investing.
But mutual funds are an expensive way to invest (wait until you hear how expensive). If you have the slightest inclination to "do it yourself" -- and make a lot more money -- I may have a better idea.
I just want what's coming to me!
In fact, with the possible 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 we earn, but our mutual fund managers are worse. They are not content with a cut of what our money earns each year (we'll assume they actually make you money). No, our fund manager wants more -- much more.
When I tell you how much more, you may not believe it, so I'll warm you up with a quick example.
Wahoo! My fund manager's a genius!
Imagine the year is 1992. The economy is stagnant, the troops are home from Iraq, and you just dumped 10 grand into the greatest mutual fund in the history of the world.
That's because your fund manager doesn't buy the gloom and doom, and he doesn't buy diversification, either. He buys American capitalism. So he rolls the dice on just four hypergrowth stocks.
You hit pay dirt! Now it's New Year's Day 2000, and just look at what's become of your $10,000 stake ...
- AOL (now Time Warner (NYSE:TWX)): $1.7 million.
- Xilinx (NASDAQ:XLNX): $51,417.
- Clear Channel (NYSE:CCU): $192,000.
- EMC (NYSE:EMC): $410,000.
Happy New Year! You're sitting on $2.4 million! Or are you? Remember, mutual funds have a price -- maybe more than you think.
Surprise! Your $10,000 isn't worth $2.4 million
Assuming your fund manager hits you up for a 2% management fee (not cheap, but hardly unheard of), you would owe him more than $40,000. That seems fair enough. After all, the fellow just made you $2.4 million. But there's a catch.
That $40,000 is for the last year alone. You've been paying out every year. In fact, by New Year's Day 2000, you'd have paid that rascal more than $85,000 in fees, and the lost profits on those fees would have cost you another $300,000 or so. And that's over just eight short years!
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 nothing? I mean, let's face it -- you're probably 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? Look no further than the list of widely held institutional stocks. I'll spare you the trouble: You'll find the likes of Home Depot (NYSE:HD) and Schlumberger (NYSE:SLB) right near the top, alongside the other usual suspects. Now, run down the top holdings in your mutual funds. See anything familiar?
Worse, even if your fund manager did stumble on a stealth bomber like Hansen Natural (NASDAQ:HANS), or any other 10-bagger for that matter, what are the chances he'd actually hold on for the long haul? More likely, he would buy and sell it many times over. You guessed it: In addition to the annual management 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 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.
Frankly, that’s wrong. Yet, for all that, you may have no interest whatsoever in researching stocks -- even with the help of someone you can trust. If so, mutual funds may be the best game in town. I’d rather see you in a good fund than out of stocks altogether, but you can agree that it's a dicey 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. Home Depot is a Motley Fool Inside Value pick. Hanson Natural is a Rule Breakers selection. The Motley Fool has a disclosure policy.
