You guys never cease to amaze me.
Was I a little rough? Yes. Did I hammer the mutual fund industry for sticking it to us? Sure. Did I expect some hate mail? Of course. But nothing quite like this.
What the heck am I talking about?
Here's a quick summary. Awhile back, I proposed a little experiment. Essentially, it was a bogus mutual fund made up of just four stocks, each bought in January 1990 and sold exactly 10 years later.
The idea was to demonstrate how a $10,000 investment in Cisco Systems (Nasdaq: CSCO), Applied Materials (Nasdaq: AMAT), Sun Microsystems (Nasdaq: JAVA), and Qualcomm (Nasdaq: QCOM) could have grown to more than $2.3 million in 10 short years. But there's a catch.
In those 10 short years, you'd have paid your mutual fund manager some $70,000 in fees and surrendered nearly $341,000 in lost profits (money gains not earned on those fees). Instead of $2.3 million, you'd be sitting on a heck of a lot less.
So you hate me, right?
Of course you do, but for a different reason than I thought. I thought you'd take the fund manager's 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 $410,000 blood money was a gross exaggeration and unfair to the industry. So you can imagine my surprise at what some of you really said. It might surprise you, too.
For more details on my little experiment, check out my column, "Don't Invest Another Penny." (But please come back, because this gets good.)
You got worked like a chump!
Or so you told me. You even used John Bogle against me. Apparently, you don't mind so much when I call Wall Street an IRS on steroids. No, you took me to task for understating the case -- for trivializing the real cost to you as an investor.
And you're right, at least on a percentage basis. Bogle makes the case bluntly in his book The Battle for the Soul of Capitalism. Among other nauseating facts, he points out that you don't need outlandish returns (like in the super-stock '90s example we just discussed) to make the case against mutual funds ... you just 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 18% of your total returns ($410,000 out of $2.3 million) in the example we just discussed. 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 be worse.
For one thing, we won't be making 23,000% every 10 years, like in my earlier example. For every Apple (Nasdaq: AAPL) your fund skipper catches for a 1,200% bounce off the bottom in April 2003, he or she will clutch a Sirius XM Radio (Nasdaq: SIRI) all the way to less than a buck. But mostly, you'll ride the widely held stocks like Microsoft (Nasdaq: MSFT) -- if you're lucky, that is.
And even if your manager does manage to catch a winner, he or she will buy and sell too often, and at the wrong times. That's one reason Bogle thinks you'll do even 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
According to Bogle, if you invest for 45 years and get his expected market return of 8.5% annually, these so-called intermediation costs can steal up to 80% of your rightful profits. You read that right, again. Not a paltry 20% like in my example, but up to a full 80%. Ouch.
For one thing, Bogle uses a more aggressive 2.5% for intermediation costs. Unlike me, he goes beyond reported "management fees" and includes taxes, transaction, 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% payout 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 outlook for stocks. Given last year's sell-off, I think we'll do better. But even if we make three times as much as Bogle expects, the percentages might be smaller, but we'll still 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 smart 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.
After all, why should you have to settle for Bogle's "market" return? Motley Fool co-founders David and Tom Gardner have earned their Stock Advisor subscribers 12% annually since 2002 -- at a time when the market has been flat. If you're interested, you can get their two top picks each month, plus their top five "best buys" for new money right now.
How? Simply accept a special free trial to Motley Fool Stock Advisor. You can try the complete Stock Advisor service free for a whole month, with no obligation to subscribe. If you do decide to join, it sure as heck won't cost you $410,000 in fees and lost profits. To learn more about this special free trial, click here.
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This article was originally published Sept. 29, 2006. It has been updated.
Paul Elliott owns no shares of any company mentioned in this article. Apple is a Motley Fool Stock Advisor recommendation. Microsoft is an Inside Value choice. Motley Fool Options has recommended diagonal calls on Microsoft. You can see all of David and Tom Gardner's recommendations, including their top five picks for new money now, with your free trial. The Fool has a disclosure policy.
