Though I am a big fan of Dave Ramsey's, we part company when it comes to investment philosophy. I'd like to outline for you why I think mutual funds—as traditionally conceived—are not always a great investment, in my view. There are times when they may be a good investment vehicle, but most people can do better without them.
If you are unclear as to what a mutual fund is or how it words, click on this handy reference- especially the links at the bottom about the advantages and disadvantages.
Mutual Fund Track Record
There are many ways to measure the performance of an investment. The most commonly used is the Standard and Poor index of 500 stocks—commonly known as the S&P500. This is the "average" of the stock market by a very broad measure. There are ways that you can invest in this very index, and pay no managers at all. This is a popular strategy.
If you are going to pay for a management team, you'd expect that they do better than no management team at all, right?
Sadly, the odds are overwhelming stacked against them.
There are almost 7600 mutual funds in the United States from which to choose, as of 2012. If you include funds that invest mostly in other funds, that number can grow to over 10,000 different mutual funds.
How do those funds compare to the S&P500?
They fail. Miserably.
That link cites the Motley Fool as saying that the probability of your mutual fund managed by "professionals" outperforming the broad stock market is less than one chance in ten thousand.
The financial industry is able to successfully perpetuate the myth that investing is too hard for the average person to do on his or her own. So they manipulate people into paying a "pro" to do worse for them out of fear. These "pros" are handsomely paid for the service of underperforming for you.
Why They Fail
Since mutual funds are, on average, below average, why do they underperform?
The main reasons they fail have to do with size. The large size of many mutual funds works against them two ways: liquidity and overdiversification.
Large funds forfeit liquidity because their holdings in a particular company represent a larger fraction of that company's shares. If a fund owns 1/3rd of a company and wants to buy more, what happens to the price? It goes up, because that increased demand is a significant increase in demand. If they want to sell, the price goes down for the same reason. Moreover, these increases or decreases are much larger than that would result from a small individual shareholder trying to buy or sell. No one even notices the small individual investor buying shares. But when the big Investment Gorilla that is a large mutual fund tries to do so, people notice much more.
As a result, the larger the chunk that is bought or sold, the less of a bargain they can get on the shares. What if you held 80% of all the shares of a company and wanted to sell them all? You'd basically lose your shirt, because the price of those shares would utterly collapse as you tried to unload them. This works in reverse if you were to try and buy a major stake in a company. The price would skyrocket and you'd overpay.
Thus, mutual funds often have to buy and sell shares in much smaller chunks so that they don't get bad pricing. But this means that they may still not get as good a price as they once could have, AND it means they end up paying a lot more in commissions and transaction feeds to execute tens or hundreds of transactions instead of one or two transactions.
Because taking a major stake in a company means that a mutual fund loses liquidity and would get hammered in transaction fees, then have to take small stakes in a much larger number of companies.
This works against them too, though. Overdiversification still keeps transaction costs high (because you have to buy shares of thousands of different companies in thousands of transactions). After that high cost, you end up *being* the average that you're trying to beat.
Consider the massive $73Billion Fidelity Contrafund. This pool of assets invests in hundreds of companies. One of those companies is Warren Buffet's Berkshire Hathaway, which is itself a holding company of that own many firms from Justin Boots to Geico insurance. So let's say that Justin Boot Company has a banner year and the profits double. If that company was its own stock, the share price may roughly double also. But because it's under the massive Berkshire Hathaway umbrella, Berkshire shares are only affected by it a tiny amount.
Because your Contrafund only has less than 10% of its investments in Berkshire, your investment in Contrafund has almost no measureable benefit from the great performance of Justin Boot Company.
In fact, Contrafund has 10 different stocks it owns that only account for a third of all that $73 Billion. The other two thirds are split so many ways that the funds owns 299 different stocks. 299!
Good Diversification vs Bad Diversification
Not all diversification in investing is good. Neither is it all bad. They key is to understand where it adds value to your investing and where it doesn't.
The more companies you own, the less safety you gain by adding another company. Going from one company to two cuts your risk theoretically in half. Going from 49 to 50 is not even worth bothering to do, so tiny is the gain is safety.
In my opinion, overdiversification can be as dangerous as insufficient diversification. By holding too many different investments, your gains get diluted and get eaten up by transaction costs and management expenses. Larger funds need more managers.
What, then does good diversification looks like?
Obviously, that is subjective. I personally think one should try to own at least 10 different companies across 3 or 4 different areas of the economy (I favor mobile tech, cell towers, real estate, transportation, and energy). I doubt one would ever need to own more than 20 companies, with 25-30 being the outer limits of what I'd ever consider. Certainly not the hundreds to thousands of holdings of a typical mutual fund.
You may be able to achieve diversification with a single stock by owning a holding company like Berkshire. Buy Berkshire and you get mobile home companies, insurance companies, railroads, jewelers, etc—even Dairy Queen. The huge list is amazing. So don't buy a mutual fund, just buy Berkshire. Warren Buffet seems to be a reasonably competent manager, they say ;)
Don't Fear Volatility
Price movement, in itself, is not something to fear if you've chosen investments in strong performers in relevant growth markets. Risk is not something that should be minimized—it is something to optimize. Minimal risk can be achieved by leaving your money in a bank. It won't grow fast enough to be meaningful, though.
Volatility doesn't always mean that something is a good investment. Commodities like oil or gold have very volatile prices, yet they are far more often gambles or speculation than investments. Investments are designed to create value—not just capitalize on a price differential. This is an important difference. Buying gold, even at a good price, doesn't create any value. It's not actively producing anything someone will pay for or bettering someone's life. That's why I do not consider commodities to be investments.
Sometimes, though, volatility occurs because investors cannot agree on whether an investment is a 10% type of return or a 70% type of return—and when those returns may happen. As they bicker, the price instantaneously reflects their conflicting assessments.
If you buy a solid company in a relevant growth market, does it really matter if it's 10% or 70%? If it was a 20% gain instead, would you be upset?
Volatility also scares off a lot of folks whose short time horizons make volatility the same as risk. If you invest for the long term—as you should—then this risk is practically moot. Who cares if the investment takes a wild ride on its way to tripling in a decade? Do you? If you never checked the investment's performance until that 10th year, you'd never know it was "volatile."
Mutual funds need not be part of a comprehensive financial management plan. Many "pros" recommend them because they are so safe that it's unlikely you will lose money and they won't look bad. Don't fall for it—a pro should not just be making money, but making money faster than the S&P500. A loss is a loss—but gaining only 3% when you could be getting 8% is also a loss, too. It's relative success that matters. You need agility to outmaneuver the big guys, so use your primary advantage—being a small individual investor—and take them to the cleaners.