Playing the Mutual Fund Lottery
A few weeks ago I was talking with Tom Wheelwright, a CPA and business owner, about why people play the lottery. His comparison of the lottery to investing in mutual funds is worth sharing.
Even though he's not an investment advisor and never presents himself as one, clients continue to ask Tom what to do to prepare for retirement. "Should I max out my 401(k) contribution?" they ask. "Should I open an IRA? Or should I put more in my profit sharing or pension plan?"
According to Tom, and contrary to popular belief, none of these are wise investments. So here, in his own words, are his thoughts on the subject.
Games of Chance
Among other reasons, 401(k)s and IRAs involve putting money into an investment vehicle over which investors have little control. And since most people end up choosing mutual funds as their primary investment within these plans, playing the lottery would be a better way to go.
Gambling away your retirement funds in a government-sponsored game of chance that you have little hope of winning? Sounds crazy, right? Millions of people buy tickets with the same hope. How sensible is it to play the lottery when the chance that you'll lose the money you put in is so high?
But the same could be said of mutual funds. After all, it's also a government-sponsored program that you have little chance of winning. So your chances of retiring on mutual fund investments in your 401(k) or IRA aren't very high, either.
A Taxing Dilemma
I once heard a radio interviewer ask a representative of a large mutual fund about the fund's performance. The rep said it had risen in value by an average of 20 percent per year for the prior two years.
But when the interviewer asked about the average return to the average investor in the fund, the representative responded that the average investor had actually lost 2 percent per year. Why? Because the performance of the market is unpredictable. Compare that to the lottery, where the precise chances of winning and the exact amount of the jackpot are known quantities.
As for the great tax advantages of putting your money into a 401(k) or an IRA, how is it a good deal to get a tax deduction when you're young and in a relatively low tax bracket so you can pay taxes on the money you take out when you're old and retired -- and probably in a higher tax bracket?
Also, consider the difference in tax rates on capital gains and dividends if you're not in a 401(k) or IRA versus the ordinary income tax rates on the earnings when you pull them out of your 401(k) or IRA.
A Gamble Is a Gamble
So should you just invest in mutual funds outside your 401(k) or IRA? No again. Mutual funds result in capital gains taxes when the fund managers trade them, even though you don't see the money. You have to pay taxes even though the fund may actually have gone down in value.
Here's something else to consider: What about the lost opportunity cost of the money you pay in taxes, which you could've put into other investments? At least with the lottery, you know the exact amount of taxes you can expect to pay if you win, and you only have to pay taxes if you do win.
I can hear you saying, "But the lottery is gambling! And I have no control over whether I win or lose!" You're right -- the lottery is gambling. But so is a mutual fund. You have no control over the stock market and neither does the fund manager. If the market goes down, so does your fund.
No Big Payoff
At least when you play the lottery you recognize that you're gambling. And you don't have the government, financial institutions, and your employer telling you that the lottery is a good investment. And your employer doesn't go so far as to match the amount you put into the lottery like it might with your 401(k).
But isn't there a better chance of making money in a mutual fund than there is in the lottery? Hardly. There may be less of a chance of losing all the money you put into a mutual fund than there is of losing all the money you put into lottery tickets, but you're never going to win big in a mutual fund.
In fact, mutual funds are designed to minimize your returns by creating a "balanced portfolio." If they could minimize the risk of the market itself, that might be OK. But the problem is that nobody can minimize the risk of the market without sophisticated hedge strategies that aren't typically used in mutual funds.
If nothing else, the lottery gives you a chance to win big, and you can sleep at night because you aren't wondering if the chances of winning are going down overnight because of something that happens in Tokyo.
Retire for Real
If you don't like the idea that most of the money spent on lottery tickets supports government programs, you should know that most of the earnings from mutual funds support investment advisors' and mutual fund managers' retirement.
You take all of the risk, you put in all of the capital, but most of the money goes to the fund manager and your investment advisor. Lottery funds go to worthy causes like schools and the arts, so which is better?
Of course, I would never advise a client to rely on the lottery for their retirement, but neither would I advise them to rely on mutual fund investments. For my dollar, the lottery is a lot more fun -- and at least you know it's a gamble.
If you really want to retire, look at other investments and work with someone who's willing to put in the time to help you retire soon and retire rich. Financial freedom is available to those who learn about it and work for it. It's unlikely for those who want to rely on such risky investment strategies as mutual funds.