This is a guest post by Robert from Flimjo.com – a blog containing some great ideas about money, and how to make more of it!. You don’t have to be employed on salary forever, get off the paycheck!

Many people think that investing in mutual funds is the way to go and the best method for getting rich. I think mutual funds are horrible investments. Here are 8 reasons why you should not invest in mutual funds.

1. Mutual funds don’t beat the market.
72% of actively-managed large-cap mutual funds failed to beat the stock market over the past five years. Trying to beat the market is difficult, and you’re better off putting your money in an index fund. An index fund attempts to mirror a particular index (such as the S&P 500 index). It mirrors that index as closely as it can by buying each of that index’s stocks in amounts equal to the proportions within the index itself. For example, a fund that tracks the S&P 500 index buys each of the 500 stocks in that index in amounts proportional to the S&P 500 index. Thus, because an index fund matches the stock market (instead of trying to exceed it), it performs better than the average mutual fund that attempts (and often fails) to beat the market.

2. Mutual funds have high expenses.
The stocks in a particular index are not a mystery. They are a known quantity. A company that runs an index fund does not need to pay analysts to pick the stocks to be held in the fund. This process results in a lower expense ratio for index funds. Thus, if a mutual fund and an index fund both post a 10% return for the next year, once you deduct The expense ratio for the average large cap actively-managed mutual fund is 1.3% to 1.4% (and can be as high as 2.5%). By contrast, the expense ratio of an index fund can be as low as 0.15% for large company indexes. Index funds have smaller expenses than mutual funds because it costs less to run an index fund. expenses (1.3% for the mutual fund and 0.15% for the index fund), you are left with an after-expense return of 8.7% for the mutual fund and 9.85% for the index fund. Over a period of time (5 years, 10 years), that difference translates into thousands of dollars in savings for the investor.

3. Mutual funds have high turnover.
Turnover is a fund’s selling and buying of stocks. When you sell stocks, you have to pay a tax on capital gains. This constant buying and selling produces a tax bill that someone has to pay. Mutual funds don’t write off this cost. Instead, they pass it off to you, the investor. There is no escaping Uncle Sam. Contrast this problem with index funds, which have lower turnover. Because the stocks in a particular index are known, they are easy to identify. An index fund does not need to buy and sell different stocks constantly; rather, it holds its stocks for a longer period of time, which results in lower turnover costs.

4. The longer you invest, the richer they get.
According to a popular study by John Bogle (of The Vanguard Group), over a 15- or 16-year period, an investor gets to keep only 47% of a cumulative return from an average actively-managed mutual fund, but he or she gets to keep 87% of the returns in an index fund. This is due to the higher fees associated with a mutual fund. So, if you invest $10,000 in an index fund, that money would grow to $90,000 over that period of time. In an average mutual fund, however, that figure would only be $49,000. That is a 40% disadvantage by investing in a mutual fund. In dollars, that’s $41,000 you lose by putting your money in a mutual fund. Why do you think these financial institutions tell you to invest for the “long term”? It means more money in their pocket, not yours.

5. Mutual funds put all the risk on the investor.
If a mutual fund makes money, both you and the mutual fund company make money. But if a mutual fund loses money, you lose money and the mutual fund company still makes money. What?? That’s not fair!! Remember: the mutual fund company takes a bite out of your returns with that 1.3% expense ratio. But it takes that bite whether you make money or lose money. Think about that. The mutual fund company puts up 0% of the money to invest and assumes 0% of the risk. You put up 100% of the money and assume 100% of the risk. The mutual fund company makes a guaranteed return (from the fees it charges). You, the investor, not only are not guaranteed a return, but you can lose a lot of money. And you have to pay the mutual fund company for those losses. (Remember also that, even if you do make a return, over time the mutual fund company takes about half of that money from you.)

6. Mutual Funds are unpredictable.
The holdings of a mutual fund do not track the stock market exactly. If the market goes up, you might make a lot of money, or you might not. If the market goes down (the way it is now), you might lose a little bit of money . . . or you might lose A LOT. Because a mutual fund’s benchmark isn’t a particular market index, its performance can be rather unpredictable. Index funds, on the other hand, are more predictable because they TRACK the market. Thus, if the market goes up or down, you know where your money is going and how much you might make or lose. This transparency gives you more peace of mind instead of holding your breath with a mutual fund.

7. Mutual Funds are sales items.
Why don’t all these money and financial magazines tell you about index funds? Why don’t the covers of these magazines read “Index Funds: The Most Obvious And Rational Investment!” It’s simple. That’s a boring heading. Who would want to buy something that isn’t exciting or that doesn’t tickle one’s imagination of immense riches? A magazine with that headline won’t sell as many copies as a magazine that boasts “Our 100 Best Mutual Funds For 2008!” Remember: a magazine company is in the business of selling . . . magazines. It can’t put a boring headline about index funds on its front cover, even if that headline is true. They need to put something on the cover that will attract buyers. Not surprisingly, a list of mutual funds that analysts predict will skyrocket will sell loads of magazines.

8. Warren Buffett does not recommend mutual funds.
If the above seven reasons for not investing in mutual funds don’t convince you, then why not listen to the wisdom of the richest investor in the world? In several annual letters to the shareholders of Berkshire Hathaway, Warren Buffett has commented on the value of index funds. Here are a few quotes from those letters:

1997 Letter: “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”
2004 Letter: “American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous.”

Bottom Line: If you want to make money, you need to copy what rich people do. So if Buffett doesn’t like mutual funds, why would you? So, if not mutual funds, what should passive investors invest in? The answer by now is clear. Invest in index funds. Index funds have lower fees, and you keep more of your returns in the long term. They are also more predictable, and they give you peace of mind.

-Jimvesting

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