It sounds so simple, all I have to do is invest my money in 12% mutual funds and I am guaranteed to have enough wealth when I get older that I will not have to worry about money any longer for the rest of my golden years. Now where do I find those illusive 12% mutual funds? All I need to do is open today????????s financial section of the newspaper and they are listed. Or maybe for the more serious investor they can purchase a popular magazine about personal investing or making fortunes and look at all the advertisements. There are several funds to choose from that clearly are making 12% or much more average rate of return. (Please note there are ZERO funds that guarantee any positive return or even the return on your investment.)
The problem with just consulting a newspaper or magazine is there is a lot of confusion and misinformation when it comes to the average American????????s financial understanding. Some of this misinformation, in many ways, misleads the public on purpose. In the ads either in the paper or popular financial magazines we are led to believe a given fund has a rate of return, when the results, (truth?) can be totally different. This misinformation can cost you dearly and expose you to risks that are hidden in what may sound like a great opportunity. As an example let????????s take a look at someone who invested $1,000 and in a mutual fund and gets an average 20% rate of return for two years.
How much would this person have? A) $1,440 B) $1,280 C) $800 D) $0. Of course we all would figure the answer as simple compound interest. Employing the math we learned in high school the answer would be A) $1,440. $1,000 with two consecutive years of 20% would be $1,440. Congratulations! We are on our way to riches and a carefree life. All I needed to do was listen to the radio get some advice and then follow it.
That is the extent of the average American????????s financial understanding. But, the sad truth what is legally advertised in a lot more complicated. Lets take a look at answer B) 1,280 could that possibly be the answer? If someone receives a 60% rate of return in the first year and lost 20% the second year that person will still have averaged 20% for two years but would have less money than answer A. So answer B is also right. Curious yet? If A and B are right what about answer C) $800? Well, if someone, let????????s say, bought some land and it went up 100% in the first year and lost 60% in the second year, this person still averaged 20% for two years but would have a lot less money than the people in answer A and B even though the average returns are all the same.
Can you see the dilemma the public is facing? Ok, hold on for the ride and look at answer D) $0. If someone received a 140% rate of return in the first year and lost 100% the second year, 100% means they lost everything, they still averaged a 20% rate of return for two years but have no money left. What is important to understand is that advertised or stated rates of return can be misleading. In this example anyone can offer you an average 20% rate of return but what does that really mean? NOTHING!
Foul you cry. That is not right, that is dishonest. Well, the hard cold reality is mutual funds can legally make such statements in newspapers, television ads, or magazines. If a fund has a down year that will affect is ??????average?????? rate of return, the parent company can just merge that fund with another fund have a higher average rate of return and presto, the average rate of return claims are restored. Yes, what is now used is the successful funds numbers not the poorly performing fund????????s.
Remember last month????????s newsletter? I encourage you to reread the article about 401(k)s and the criminal fees that are being charged. Similar things are going on with mutual funds. I have a fund that is tied to a 401(k) I had while working in the San Francisco area 11 years ago. The fund reports positive average rate of return for those 11 years. My personal experience? I have a small number of dollars than I started with. Not to mention each dollar????????s purchasing power is less. Where has the gains gone? FEES. I categorize them as one of the silent wealth killers.
How do mutual funds perform in light of the 12 points of an ideal investment? (See here: http://financialfreedomrestored.blogspot.com/2013/10/12-characteristics-of-ideal-investment.html)