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The Devious Genius of Mutual Funds

How a market crash helped me pull back the curtain to see how Wall Street is ripping us off

As my wife and I began to look closely at the many mutual funds that made up our retirement accounts, one thing became very clear to us. We realized that the stocks held in most of these mutual funds were very basic “no-brainers” you could read about in financial newspapers and magazines. We were not convinced that whoever was managing these mutual funds were doing any research or adding their expertise. I still remember feeling that I could have picked those same stocks myself, even though I knew almost nothing about stocks in those days.

In looking at the specific stocks those mutual funds were buying, I saw companies such as Nokia, AT&T, Enron, and other big names. During those years, these were high-flying stocks everyone knew about. They were the stocks everyone wanted to buy. Where was the genius in that on the part of the mutual fund companies? Suddenly I realized there was no measurable value in the analysis influencing their stock picks. Instead, the genius of mutual fund companies was focused on something entirely different: How to take money from my account with as little work as possible.

That experience was the painful kick in the pants I needed to improve my own financial education. It was also the beginning of my research into the 401(k) industry and the mutual fund system as a whole. The more I discovered about how these companies operate, the more disgusted I became. As I uncovered statistics and reports, and applied a bit of common sense, the picture became very clear to me. It seems the mutual fund industry is more about making money for the large institutions than it is about making money for the investors—people like you and me. But that’s only half of it. The laws put into place by our legislators to make 401(k)s possible also acted like fertilizer for this industry. As a result, the whole mutual fund and 401(k) industry is growing like crazy. And it didn’t take long for me to understand why that fertilizer smelled like it came from a bull.

Selling mutual funds became extremely lucrative for these institutions and the industry absolutely caught fire. Unlike hedge funds, mutual funds could aggressively advertise for new investors. As they flexed their marketing muscles, the money came rolling in. And it still rolls in today. These companies that promote their mutual funds and 401(k) programs have a powerful money machine. When the money flows in so fast, the perspective of the funds can easily become skewed and distorted. The focus can shift from serving the fund’s investors (you and me) to serving themselves (the managers and shareholders).

Part of the marketing message put out by these huge financial institutions is that they have the experience and expertise to help grow your money. But the more I study the industry and how these companies operate, the more I am convinced that mutual funds and 401(k)s were created chiefly to make these institutions rich.

How Big Is Big?

To measure how much wealth a country is producing, economists add up the value of all the goods and services created in that country during a given time period. It’s called Gross Domestic Product (GDP). In 2009, the finance and insurance industries made up 8.3% of the U.S. GDP. That is $1.1 TRILLION dollars—a massive amount of money. With that kind of money at stake it’s no wonder these institutions are competing aggressively for their share.

How long will it take before the world realizes that these retirement plans were not created to solve their retirement problems? When will it become clear that these are the inventions of people who saw an opportunity to make a lot of money by creating wide-mouth funnels that continuously pour money into their own bank accounts at the expense of honest, hard-working people?

John Bogle is a legend in the mutual fund industry and is the founder of Vanguard, one of the largest mutual fund companies in existence. In 2006, Bogle wrote a scathing letter to the SEC (Securities and Exchange Commission), the government body that oversees the investing arena in the United States, regarding the shift from wisdom to greed that has occurred in the mutual fund industry. He called for improved regulation to help prevent the abuse of investors by fund managers. Among his many chastisements was this statement that gives a clear and appropriate summary of the situation:

“I have many concerns about the prevailing levels of conduct and values in today’s mutual fund industry. But my overriding concern is that funds are operated largely in the interests of their management companies, rather than in the interests of their shareholders.”

Why is my money being invested with companies that create a system that ignores my goals?

Wall Street greed is nothing new, of course. It really shouldn’t be surprising to learn these things because the public is already suspicious of Wall Street. Based on past actions, it’s reasonable to be suspicious of their motives. From Eliot Spitzer’s attack on mutual fund scandals to more recent headlines exposing guys like Bernie Madoff, it’s definitely not unusual to find greed as the main goal for these people. What is so shocking is the amount of lies and deceit being fed to us.

You Are Sitting on a One-Legged Stool

When the 401(k) plan was first introduced, it was never intended to shoulder the entire burden of your retirement. In fact, back in the late 1970s people often talked about the “three-legged stool of retirement.” These three legs were: (1) the employer’s pension plan; (2) Social Security benefits; and (3) personal contributions.

We will explore this topic in depth later in this book, but I think it deserves a brief mention here. In a nutshell, this three-legged stool is getting very shaky. Thousands of companies have eliminated their pension plans. Social Security is on very thin ice, and most people who are due to retire in the next 10 to 30 years don’t expect to receive what they were promised from this forced savings program.

Now it looks like the third leg of that stool, the personal contributions to the 401(k) plan, is being forced to take on all of the responsibility for your retirement. The problem is that even in the best of economic conditions your 401(k) plan simply cannot grow enough to give you the amount of money you deserve when you retire.

And the problems don’t stop there, because we are NOT in an ideal economic situation. We have been hit head-on by two strong market crashes in recent years. On top of that, the debt level forced upon us by the federal government has put all of us at the cusp of yet another bursting bubble that will push the markets even lower for a longer period of time.

If it’s not clear to you how this will seriously damage your retirement outlook, consider this:

• Your 401(k) account will only increase in value if the market goes up. As the dollar continues to get weaker because of our massive government debt, the market will eventually crash again. Your 401(k) account needs plenty of time and big market gains to do its part in helping to fund your retirement. However, time is running out as the overall economy continues to be shackled by debt problems that will not go away anytime soon.
• Another side-effect of the dollar becoming weaker—which it will—is that inflation will rise. Why is that a big deal? Because when it’s time for retirement, you’ll need to determine if your 401(k) account will be big enough to cover the steep price increases that inflation will bring. For example, will you be able to afford $10 per gallon to fill up your gas tank? Will you be able to enjoy a healthy salad at $5 for a head of lettuce and $2 for a tomato?

When you look at the inherent problems with 401(k)s, and then put that problem into the context of the bigger problems facing our economy, it’s easy to get overwhelmed. It’s chaos within chaos. It’s like trying to board up your house with a broken hammer to protect it from the coming hurricane, only to find out you don’t have nearly enough nails and plywood, and the hardware store is long sold out. You know you need to do something, but it seems you are all out of options.

These coming storms have a profound impact on economies at the national level. But with their 401(k)s and mutual funds exposed to so much more risk and downside potential, I’m frightened to think of the effect they will have on hard-working individuals and their families.

The effect that 401(k)-type plans will have on the middle class will grow to become one of the next major financial tragedies we will face. It’s looking at us square in the eye today. Even though contribution retirement plans are legal and growing, they will fall apart in the same way that many illegal scams do. Unfortunately, it’s the little guy who will suffer the greatest injuries.

The 401(k) system will eventually cause massive problems for the stock market and for the average retirement plan participant. But there can be light up ahead for people who make wise decisions.

We will see that this storm doesn’t have to be a frightening surprise when it really hits hard. That’s why we will look seriously at why you and I now need a more comprehensive financial education to survive and even thrive when the rain and winds come at us full force.

The Real Problem Is Ignorance

The SEC does its best to regulate the industry and protect investors. They conduct investigations as they work hard to look out for the little guy. They prosecute those who are shady business people. However, there is one thing I have learned through my research and as I’ve pursued my own financial education: It’s impossible to truly protect the ignorant.

Congress can pass laws all day long, but those laws will not make people smarter. It’s up to us individually to improve our own financial intelligence. Greedy folks will find ways both within the law, and outside of it, to pick our pockets. The only person who can protect your money from these sharks is YOU. Laws and regulations are no substitute for experience and education.

One goal you should make for yourself is to ask the hard questions of your advisors. I also want to help you analyze your own situation to determine if you are invested properly to achieve your personal goals and objectives. Armed with this knowledge, you and your advisor can work together more effectively as a team to truly improve your investing approach.

To begin educating yourself on how to understand how many works in the economy, in your life, and how you can grow it for yourself, I recommend starting with my course called The 4 Pillars of Investing.

Go here to learn about The 4 Pillars of Investing and enroll today.