Why do you hate mutual funds so much? August 7, 2008Posted by shaferfinancial in Uncategorized.
Tags: diversification, Financial Advisors, mutual fund sales people, mutual funds
Yep, you guessed it, I get this question a lot. In fact, sitting on my porch with some neighbors espousing the philosophy of the Shafer Wealth Academy, I got it asked in a much nicer way. So I thought I would answer it directly for the readers.
There are three reasons:
1. Diversification sucks. There I have said it. There is an open secret in the investment world that diversification is for suckers or at least for folks that will never capture wealth. You see, mutual funds were invented as a marketing strategy. After academic finance disclosed you could reduce risk (variance) by diversification, astute Wall Street companies knew they could market this to average folks. Previous to mutual funds and the idea of diversification the average person felt that investing in the stock market was akin to gambling and shied away from it. But those folks in Wall Street knew a good marketing opportunity when they see one and ran with it. Diversification reduces the variance to a point where the likely outcome is single digit returns. Single digit returns are fine if all you want to do is beat inflation, but it will never create wealth. What started as propaganda aimed at getting average folks to own stock has turned into common advice that is demonstrably wrong. Every wealthy person from Warren Buffett to Donald Trump when being honest tell us that concentration is the way to go. Diversification before we obtain wealth is a fear based strategy. People think by diversifying, when things go badly, they can hang on to some of their wealth. Unfortunately, diversification is a block to building wealth, so they are protecting themselves from a loss that means nothing. Since fear keeps most folks from building wealth, when they hear diversification can protect them, they jump at it. Its a perfect fit for a fear based environment. Not that fear is a totally wrong emotion to have for the middle class. After all this is a group that is experiencing the economic changes most acutely.
2. Mutual funds are retail products so there is an extra hand (middlemen) between you and your investments. Even the lowest cost mutual fund company has employees that must be paid, buildings that must be leased or bought and profit that is made. Where does all this money come from? Yes, your returns. See how this all blends together. In order to get diversification you need to buy mutual funds, which not only creates a profit center between you and your investment but also implicitly requires you to look toward others for financial advice.
3. The sequence of returns issue is real and devastating as millions of recent retirees have found out. You don’t have time to make up for losses when you have a major bear market 5 years before or after retirement and it ends up devastating the amount of income you have at your disposal.
A few words on why mutual funds are so popular. I’m sure the denizens of Wall Street never imagined the success of mutual funds when they first designed them. As it turns out they were ideally suited for the psychology of the middle class. The middle class, especially during the last two decades of the 20th century, were looking for security. Remember, previous to 1980, layoffs were non-existent, defined benefit pensions were what most people had, and retirement for most was usually less than 10 years before death. Security for the middle class was the name of the game. The economic insecurity of the early part of the century eventually got turned on its head, but this was just a temporary reprieve. Education beget a good job, which brought economic security. Enter an investment strategy called mutual funds, which offered as its main selling point security (even though this was false, it matters only what people perceptions were). In other words, mutual funds fit right in to the way people thought about and approached their financial life.
Then the stability of the middle class was turned on its head in short order. Layoffs became common place not only for industrial workers, but for middle management and technical workers. Aerospace engineers became perhaps the first middle class victims of this change in the 1980’s. The government along with Wall Street stepped in and created IRAs and 401Ks ostensibly to encourage retirement savings, but also to pump up their respective cash flows. We are just now starting to see the results of this unholy trilogy (Wall Street, Government, Security Seeking Workers). The noise has reached a crescendo about the lack of retirement funds for the current generation of retirees. Yet, few question the strategy that brought us to this point??? And of course, the latest dependency; home equity. If you were depending on your home equity to fund your retirement, the bubble has now burst.
So there in a nutshell is why I rail against mutual funds. It is an outdated investment strategy for the world we live in now. Never was honestly sold. And absent financial education as to the realities of the current economic climate, causes and will cause much financial pain at the exact time (retirement) that folks can least afford it.