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Picks stocks for retirement

Chris Farrell Jul 7, 2010

Question: My retirement savings are currently invested only in mutual funds. A financial advisor told me that mutual funds have many hidden fees that are not apparent to the public, sometimes adding up to 8% or so, and recommends only individual stocks. I have been poring over all kinds of annual reports and documents, but can’t understand the fees they do disclose, much less whether there is anything hidden. Are there really these hidden management or other fees? Thank you. Amy, Boulder, CO

Answer: I’m going to strongly disagree with the financial advisor, especially when it comes to saving for retirement. Stock-picking is a loser’s game. You don’t want to tie your standard of living in old age to the fortunes of a handful of companies. When it comes to stocks and your retirement portfolio the foundation should be a low-cost low-turnover no-load broad-based equity index fund–not individual stocks.

Frankly, I have no idea how the financial advisor came up with an 8% figure in hidden fees with actively managed mutual funds, at least not on an annual basis.

John Bogle, the octogenarian founder of the Vanguard mutual fund behemoth, is a vocal critic of mutual fund fees. And he does come up with a big number, but it’s 2% to 3% annually for an actively managed stock mutual fund. He comes to that figure by adding together the typical active mutual fund expense ratios of 1% to 1.5%; the hidden costs of portfolio turnover of 0.5% to 1.0%; and a 5% front-end sales load that he amortizes over a holding period of 5 to 10 years.

When you look at a mutual fund prospectus or research funds at a website like Morningstar you’ll easily see the expense ratio. You’ll also see whether or not the fund imposes a “load” (a fee to invest open an account) or not. The only “hidden” fee is the cost of the money manager buying and selling stocks. It’s an estimate backed by scholarly research, though.

I’m not a fan of actively managed mutual funds but you can invest in really good ones for way less than 8% with Fidelity, American Funds, and T. Rowe Price to name just a few notables. There are commission and other costs associated with buying and selling individual stocks, too. And, most importantly, you lose the benefit of diversification. I think that’s way too high a price to pay.

Better yet, the all-in annual cost of owning a broad-based equity index fund is about 0.1% to 0.2%. The low fee is one reason that S&P 500 equity index funds typically do better than 60% of all large capitalization funds over the years. It’s a slam-dunk bet that the record of most stock pickers is much, much worse. (And every major investment legend I have come across like Jeremy Grantham, Warren Buffett, David Swensen, William GRoss, and Barton Biggs would agree with that assessment.)

The reason to invest in individual stocks is that it’s fun. You match your wits against the market. You take a plunge on an investment idea. But the money you’re investing should be “play” money or “mad” money. Whatever you call it, much like visiting the casinos, going to the movies, or traveling to Disney World, the sums you invest come out of your entertainment budget. It’s money you can afford to lose and enjoy if you win. But I wouldn’t put my standard of living in retirement, my children’s college education, my emergency savings, and the down payment on a first home at risk to my stock-picking prowess.

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