[Editor's Note: Many medical journals often publish “Pro/Con articles” especially about controversial topics. In this post, Loy Puckett, MD, and I debate the pros and cons of investing in mutual funds. Loy is also an emergency physician with an investing blog called Physicians in Finance. We have no financial relationship.]
Mutual funds aren't what they used to be. They used to be the cat's meow back in the 1990s when we were riding a huge bull market and investing in the stock market was extremely popular. Now, not so much. The total number of mutual funds in existence currently has risen astronomically. So, these days they are a dime a dozen, and the performance of individual funds across the board is nothing to write home about. I will never be investing in another mutual fund for the rest of my life, and here are some reasons why.
Costs of Investing In Mutual Funds
There are several costs to you, the individual investor, which may not be very apparent unless you are reading the fine print of your individual fund prospectus. The fund will charge you fees for the management of the fund. They will charge fees for multiple redemptions which often are done due to decisions by individual clients withdrawing funds as opposed to being a trading strategy of the fund manager. You are also charged the dreaded 12 B1 fee. The 12 B1 fee is a marketing fee which was originally created to try to help improve the performance of funds by offsetting other costs. According to Investopedia, this has not proven to be the case. These costs certainly impair the overall return on principle of individual investors.
Loss of Control
When you invest in mutual funds you have no control or decision-making in which stocks you will be investing. What is the entry point? What is the exit point? The larger the fund, the much higher likelihood that stocks will be bought at the wrong times in order to even out a portfolio. The turnover rate for individual stocks over the course of the year is quite high in most cases. This means that the capital gains will not be long-term capital gains, and as a result, individuals will be taxed at their current tax bracket. You'll also get taxed on dividends that the fund pays even if you reinvest those dividends in the fund. In addition, for a particular fund, the manager could change at any time. As a result, the investing strategy might change. How do you know that the new fund manager will stay with the strategy of growth versus changing to an income strategy.
The 401K Problem
I understand that many individual investors will be employees that are using a 401(k) plan and are essentially stuck. There really isn't any opportunity to invest in individual stocks, and the options for mutual funds are limited to those which are available in the employer's plan. This makes the chance of getting a great return even more unlikely. I think tax-deferred plans are good, but I hate that the only way to participate is through mutual funds.
Buy, Hold, and Pray
The last point I'd make is that the concept of “buy, hold, and pray” when investing in mutual funds doesn't work, in my opinion (and this is the pathway many investors in mutual funds will take). You're throwing a dart at the calendar and saying that's the date when I want to retire, and you hope that the money will be there. The problem is if that dart had landed on the year 2008, things didn't work out so well. The last question is: How many wealthy people do you know that made their money investing in mutual funds? I leave you with that.
Pros of Investing in Mutual Funds
Mutual funds provide instant diversification. With one click of the mouse I own shares of literally thousands of different companies and can share in their profits.
Mutual funds provide professional management. Whether you’re a believer in the magic of active management or whether you prefer a more scientific approach to investing, a mutual fund comes with a built in manager. You don’t have to pick the stocks that are going to do well and sell the ones that are going to do poorly. Nor do you have to figure out how to replicate and track an index. Someone else does all the work for you.
Lower Investing Costs
Mutual funds allow for economies of scale with investing costs. My physician partnership bands together with other groups to negotiate with insurance companies and provide benefits. This approach benefits all of us. In investing, I band together with thousands of other investors to share the costs of running a fund. As a result, it is cheaper to invest together than to invest separately. For example, I own shares in the Federal TSP program. The costs (expense ratio) of these mutual funds are approximately 0.02% per year. That’s 20 cents per thousand dollars invested. There are no loads, commissions, fees, external bid-ask spreads, and no 12b-1 fees. Some of my mutual funds cost me a little more, but on average, my entire portfolio has an expense ratio of 18 basis points, or $1.80 per thousand dollars invested.
Keep It Simple, Stupid
Mutual funds allow you to minimize complexity. Using just one mutual fund, the Vanguard All-World Index, you can buy essentially every single stock in the world. All of them. One investment. You don’t have to keep track of paperwork coming from dozens, hundreds, or even thousands of individual companies. You don’t have to follow them in case something happens that would cause you to need to sell the stock. And you certainly don’t have to keep track of the cost basis on the individual stocks in the portfolio. You only have to fill out Schedule D once to realize you don’t want to do 5 pages worth of Schedule D every year, much less log into your computer all those times to do the actual transactions. Even if your 401K requires you to go through a brokerage account to get any decent investment choices, you can still buy mutual funds called ETFs through any brokerage account.
Mutual funds allow you to follow a scientific approach to investing. The literature demonstrating the folly of active management is robust. Full-time professionals cannot pick stocks well enough to beat the market over the long run, and they fall far behind once the costs of doing so (not to mention the taxes) are added in. The recently released S&P Persistence Scorecard demonstrates that professional stock pickers cannot beat a passive investment. If a pro can’t do it, what are the odds that an amateur running a busy practice can? Overconfidence in stock-picking leads to sub-par returns for the vast majority of amateur stock-pickers. In my experience, few stock pickers even know how to calculate their own returns.
More Disadvantages of Investing In Mutual Funds
Just Buy The Good Stocks
Owning thousands of stocks in a mutual fund is not something I would call a good thing. In all likelihood, you are owning at least some stocks at prices that are too expensive. This probably means that they own some crappy stocks, as well. If I'm investing for value or growth or income, I only want to own stocks that have great intrinsic value. There's nothing overconfident about that. Just good logic. Doing this does not require a deep understanding of business, nor does it require a tremendous amount of time. It can be as simple as subscribing to a newsletter that has most of this information. This is money well spent and is part of your investment.
Individual Stock Investing Doesn't Take Much Time
I don't buy the argument that all physicians don't have the time to learn and manage this scenario. Many physicians may feel they don't have time to learn about stock trading or stock investing, and I would agree that you shouldn't do this if you have absolutely no interest in the subject. Not a good idea. Yet, since one of the ways that we physicians can build wealth is through our investments, we would want to get the best return on investment that we can. And, since we probably don't have the time to invest in real estate or to invest in our own separate nonmedical business, stock investing is a better alternative for most of us. A portfolio of individual quality stocks that are each bought with a predetermined risk and a predetermined goal of return and exit point is excellent diversification and provides a better return than just throwing money into a mutual fund.
Jack Bogle Points Out Flaws With Mutual Funds
Mutual funds have had a dismal performance in recent years, and this has been tied to costs and asset turnover. Jack Bogle has pointed out that the returns on mutual funds are severely impaired by major expenses and by the fact that fund manager goals in investing don't coincide with what is the best interest of individual mutual fund investors. According to Bogle, although mutual fund assets rose 1600 fold from 1950 to 2004, the costs increased by 2400 fold. These points can't be ignored when trying to determine if mutual fund investing will give you the best possible return on your investment.
More Benefits of Investing In Mutual Funds
Buy And Hold Not Dead
Buy and Hold Investing is like Democracy and Capitalism- it's the worst way to invest except all the other ways that have been tried. Just because the last decade contained two big bear markets the pundits have been declaring that Buy and Hold is no longer a viable investing option. But a look at the data reveals that Buy and Hold works just as well as it ever has. Annualized 10 year returns for commonly held Vanguard index funds show 7.93% for Total Stock Market Index, 9.41% for Total International Stock Market Index, 6.25% for Intermediate Bond Index, 11.68% for REIT Index, and 9.61% for Small Cap Value Index. 20 year returns are even better. Timing the market is far less important than time IN the market. As Warren Buffett likes to say, “My favorite holding period is forever.”
Newsletter Writers Have A Poor Record
Mark Hulbert, who publishes The Hulbert Financial Digest, a newsletter analyzing the performance of investment newsletters, revealed in January 2001 that of the 160 newsletters it tracks, only 10 had beaten the market on a risk-adjusted basis over the previous 10 years. Picking the right newsletter in advance seems at least as hard as picking the right active mutual fund manager or the right stocks. There is great wisdom in humbly acknowledging that you cannot predict the future, and neither can anyone else, so you need an investment plan that doesn't require that knowledge.
Index Funds Own All The Winners
While it is true that an index fund owns all of the bad stocks, it is also true that it owns all of the good stocks. By owning an index fund I will own the next Google, the next Apple, the next Microsoft, and the next eBay, as well as all the long-time favorites like GE, Proctor and Gamble, and ExxonMobil. When you examine the data in any type of reasonably scientific manner, you'll realize you're far more likely to achieve investing success by just buying all the stocks than by trying to pick the winners. Loy's investing method requires you to not only pick the right stocks and buy them at the right time, but also to sell them at the right time. There are very few people on the planet who can do that successfully over the long run. With regards to timing the market, Jack Bogle, the founder of Vanguard, says this:
“I don't know anyone who's ever got it right. In fact, I don't know anyone who knows anyone who's ever got it right.”
Neither do I. But I know lots of doctors and other smart people who have gotten it wrong. I also know of hundreds of Bogleheads, who invest primarily in mutual funds, who are millionaires. Successful investing doesn't have to be complicated.
What do you say? Continue the debate in the comments section below. Keep it civil and focused on ideas, not people.