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Why do you hate mutual funds so much? August 7, 2008

Posted by shaferfinancial in Uncategorized.
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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.


1. TJ - August 8, 2008

>1. Diversification sucks.
>2. Mutual funds are retail products so there is an extra hand (middlemen) between you and your investments.
>3. The army of mutual fund sales people have no idea how to get wealthy because they aren’t.

Yet you like IUL? How does that get passed your objections?

2. shaferfinancial - August 8, 2008

TJ look at my posts on IULs closely. I like them, not because they create wealth, but because once wealth is created, they hedge wealth against taxes and inflation.

If mutual funds were sold as a hedge against inflation then I would accept them for that purpose. But they are not are they? Aren’t they sold as a wealth creating instrument? Aren’t mutual funds inside a 401k/IRA sold as a tax reduction strategy? Aren’t they sold as a retirement income tool?

Facts are I have told at least 5 people in the last month, to hold off purchasing an EIUL until they have developed a working wealth building strategy.

TJ, do you disagree with my three reasons for disliking mutual funds? If so, maybe you could move the discussion ahead by telling us why?

3. TJ - August 8, 2008

David –
I’ll take a stab at this in the few minutes I have before my next appointment…

I have read your posts on IUL’s. First, there is quite an assumption loaded up in the idea that IUL’s “hedge wealth against taxes and inflation” as you say. Let’s address taxes first. Yes, the accumulation inside ANY life insurance policy is sheltered from taxes while the policy is in force. That’s an important consideration, because anyone who wishes to actually USE the cash in an IUL is putting “pressure” on the policy such that it is more likely to lapse (creating an UGLY tax situation). We may or may not have discussed “overloan protection riders” within these policies, but once you add these in you start to destroy the very same “inflation hedge” that you claim exists. Factor in the possibility that mortality expenses might blow a policy up and, well, I still don’t like them much. As for the “inflation hedge”, yes, I think a pure indexing strategy of an IA or an IUL will outpace inflation. But the IUL has the drag of mortality charges to factor in.

Briefly, yes, I think mutual funds are sold as a wealth creation instrument. And I think they are also sold as an inflation hedge, although I suspect many mutual fund buyers don’t really understand that. That being said, let’s look at your three objections.

(Client is here, I will finish in my next post.)

4. TJ - August 9, 2008

OK, I’m baaaack! 🙂

First, a note, after having slept on things last night. What strikes me most is that your three objections to mutual funds aren’t really objections to the mutual funds themselves; rather you object to how they are sold and who sells them. And since I know that you like IUL’s, I immediately thought of the similarities. So let’s start there.

1. Diversification sucks.
On its face, I don’t agree with your premise. Diversification, like Jim Cramer says, is “the only free lunch”. I think diversification is a good thing. Can it be taken to extremes? Sure. But so can anything else, as well. You use several logical fallacies in your argument against diversification. I can address that in another post if you’d like, but for now, if we compare mutual funds to IUL’s in this arena, you can’t possibly make the claim that IUL’s are somehow more “concentrated” than mutual funds. If, as you claim, you like IUL’s for wealth preservation and tax reduction, how can you not like mutual funds for the same reason?

2. Mutual funds are retail products so there is an extra hand (middlemen) between you and your investments.
Mutual funds are a retail product. But so too is IUL, and I might argue that IUL has more hands in the “cookie jar” than mutual funds do. So again, if we are talking about a vehicle that is not designed for WEALTH BUILDING, but rather inflation and tax hedging, I’m not sure how you position IUL as more favorable than mutual funds.

3. The army of mutual fund sales people have no idea how to get wealthy because they aren’t.
With your stance on IUL, you have made a not-so-subtle implication that mutual fund sales people don’t know how to get wealthy, while IUL salespeople do. Further, you have another logical fallacy here. Let’s address that in another post as well.

Correct me if I am wrong, but it seems that your biggest objection to mutual funds is that they are mis-sold (as a wealth building tool vs. tax/inflation hedge). If that’s the case, your objection isn’t with the vehicle itself, but with the way that it is sold/used.

5. BawldGuy Talking - August 9, 2008

“Diversification are for those who don’t know what they’re doing.”

Warren Buffett

Think I’ll go along with ol’ Warren on this one. 🙂

On another subject, seems mutual funds are somewhat if not exactly analogous to real estate investing when it comes to the amount of leverage to employ. Grandpa would use less, (mutual funds) while RE investors of today would sometimes opt for more.

Sorry, couldn’t resist. 🙂 This post is easily a Bawldy Award winner. Great stuff, thanks.

6. TJ - August 9, 2008

Tell that to this guy’s clients:


Se if it makes them feel any better.

7. shaferfinancial - August 9, 2008


You got me its not the product just the way it is sold and used!

The reason diversification sucks is it inhibits rates of returns that can reasonably build wealth. I wait the mutual fund sales person that says, “I think you should invest in mutual funds because, although data demonstrates a 4.4% rate of return over the last 20 years for individuals investing in mutual funds, you will beat inflation.”

The problem as you know, is that a majority of folks in this environment, are totally on their own for building retirement income, since the defined benefit pensions went the way of the dodo bird. Mutual funds have been sold as a way to solve that problem, when it doesn’t.

The reason I like EIUL’s FOR PEOPLE THAT HAVE OR WILL ACQUIRE WEALTH, is the tax benefits. The numbers demonstrate for people that expect to pay 25% or more in taxes that EIUL’s (including mortality fees and middleman expenses) will get them a greater amount of income in retirement over mutual fund investing. In addition to that, there is a death benefit that will go along for the ride that will significantly increase the rate of return in a significant minority of cases. In fact, for men, 15% will die between 45 and 65 years old and 23% between 45 and 70. For these folks they will have a even higher rate of return and significant tax savings. For those reasons I prefer EIULs over mutual funds.

Now, in the case of mutual funds, I have an ability to avoid the middlemen and solve the rate of return problem by learning to invest in equities which includes learning how to analyze businesses (a whole host of good things happen when one learns to do this). The average person can build enough wealth by becoming an investor to solve the retirement income problem. For insurance, the average person can’t avoid the insurance companies. Not that they would want to because the insurance companies have negotiated a pretty good tax deal with the government for their life insurance product.

Now I can’t argue against the thought that for people who aren’t going to amass enough wealth to pay above the 15% rate or who don’t need estate management strategies that a reasonable bet is to invest in mutual funds, and attempt to increase the rate of returns as best you can through low expense funds and dollar cost averaging. But that is what it is a bet against rising tax rates, early death, and high inflation!

8. shaferfinancial - August 9, 2008

TJ, Bawld Guy already covered that one at nctimes “….for those that don’t know what they are doing.” You can’t protect people from ignorance. If fear is all you have to sell then you are in trouble.

9. investmentblogger - August 12, 2008

Another thing about the way they are sold is that the people selling the mutual funds never suggest their clients to sell them and hold cash, even when the stocks held inside them have become overvalued or the market is about to bust. On top of that when the mutual fund tanks, they suggest selling it to buy a different one. This has led many individuals to suffer huge losses each time the market drops significantly. The average person can only sustain that so many times before they have nothing left, which unfortunately is the case for many of the baby boomers within the last decade who are soon to retire with nothing.

10. shaferfinancial - August 12, 2008

Exactly right “investment blogger.” The underlying environment for mutual fund sales is be passive, let the money manager/sales person make the decisions, and all will be well. This is factually wrong. All the data points to this being wrong. The Shafer Wealth Academy helps people do the opposite. Learn to be an active investor, making the decisions yourself so YOU learn and improve. People have the ability to learn to become successful investors if given the right information and the right motivation. As to EIUL’s it is simply a way to hedge against inflation and taxes. Is it a perfect product? No, but as of right now it does do the things I want from it, if correctly set up!

11. Peter Gregory - December 11, 2008

David, this headline just caught my eye, and I so completely agree with you.

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