You Won't Get Rich Investing in Mutual Funds

Investors are forever torn between fear and greed. Greed is why they are in the market - to get rich, preferably quick. Fear is why they want to "play it safe" so as not to lose their shirts in the process. As a result, the majority prefer "low risk, high return" investments - something that does not exist in real life as return is ALWAYS commensurate with risk.

Mutual fund marketers know this and pitch diversification for safety and "professional stock selection and management" for high return potential. But do you know of anybody who got rich investing in mutual funds? Ever wonder why?

According to the 2009 Investment Company Fact Book, there are over 4,000 actively managed stock funds, but aside from Fidelity Magellan when it was managed by legendary Peter Lynch, how many can you name that have consistently outperformed the market for a decade or two? Not a quarter or a year, but a decade? It is important as mutual funds are long term investments and a year of out performance can be canceled out by a decade of mediocrity.

Many investors chase performance, buying the hottest mutual fund of the moment, only to watch it move to the bottom of the pile. And it never seems to be the same mutual fund at the top. Every quarter, a new winner. Why? And how come nobody can ever predict the next big winner?

The answer is in how mutual funds operate.

Positions / Performance
When it buys a stock, a mutual fund pours millions into it, buying thousands or even tens of thousands of shares. Such huge purchases cannot help but move the price, so mutual funds have to build positions gradually over time, and only in stocks that are sufficiently liquid - larger caps off their highs that are basing. And herein lies the problem: a mutual fund has to buy stocks it thinks will go up, not the ones that are actually going up - like individual stock traders do. The window of opportunity in a breakout is too small for a mutual fund to establish a meaningful position. Nobody knows (including the managers themselves) when, or even if, their picks will move. As a result, mutual fund portfolios are full of stocks going nowhere for months, even years. Every once in a while they get lucky and their largest position has a run, propelling the fund to the top of the group for a quarter.

But that kind of outperformance is hard to replicate. Since mutual fund managers eschew timing, there is no guarantee that your fund will continue to outperform the next quarter, and the quarter after that. More likely, somebody else's stock pick will move next, making them the hottest fund of the moment. And so on. You can't win.

Management
Few mutual fund managers are good stock pickers. Most are mediocre. And like the rest of us, they often hop from job to job. Mutual funds companies are aware of that and emphasize a fund's style/objective over an individual manager's skills. So you may be buying the hot performance of a guy who has just left, replaced by an unproven rookie. Magellan has never been the same since Lynch left.

Cash Flow - Diversification
Mutual funds have limits on the amount of stock in a company they can own. They also must stay fully invested. As a result, what they buy is largely determined by the amount of money they have, not by market opportunities. If investors pour money into it, a hot mutual fund must buy something, even if there is nothing to buy. The mediocre stocks the fund must hold hurt returns.

In a nutshell, mutual funds cannot do what it takes to produce superior returns. Plain and simple.