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Suppose somehow that you collect a non-negligible amount of cash and want to invest it. If you are investing for the long-haul, then common stocks are your only reasonable choice since they offer the best return. According to the Efficient Market Hypothesis, all stocks are fairly valued because everyone on Wall Street has the same information. So unless you have friends who will give you insider information, there is no reason that you should buy Microsoft rather than General Motors. Sure, Microsoft has a monopoly and GM doesn't, but Microsoft's monopoly is already reflected in their lofty price/earnings ratio and GM's perennial engineering and management problems are already reflected in their absurdly low price/revenue ratio.

If you buy into the Efficient Market Hypothesis then you're just as happy to buy a portfolio of stocks selected by throwing darts at the inside pages of the Wall Street Journal. In fact, the WSJ for many years pitted expert wall street analysts against a dartboard portfolio and the darts almost always did better. If you don't have very much money, then a problem with a dartboard portfolio is that you will only be able to buy a few stocks. Your expected return will still be 7 percent per year but the variance will be extremely high because one company going bust could wipe out all of your gains.

Mutual Funds

Here's where Wall Street professionals step in, eager to help you. If you don't like all that risk, join our mutual fund, the Chump Fund. You give us $10,000 and we'll give you a share in our $10,000,000 portfolio with lots of different stocks, all chosen by Harvard MBAs. We'll skim 2% off the top every year to pay for our office space, salaries, computers, and mailing out advertisements to other people like yourself. You might not like paying the 2%, but look at how much better we've done than the S&P 500 index over the last five years.

So you buy into the Chump Fund. Halfway through the year, the Harvard MBAs are tired of their drab offices and Pentium computers. Do they take part of the 2% and move uptown and then buy Pentium Pros? No. They discover all of a sudden that they shouldn't have any General Electric. Westinghouse is really a better investment. And Ford is looking better than Chrysler now too. In fact, the entire $10,000,000 portfolio needs to be traded. Do your mutual fund managers, who've sworn to look out for your best financial interests, execute the trades with the broker who has the lowest commissions? No. After all, the money for trading commissions comes out of your 98% and not their 2% (read the fine print). So why not go to a "full-service" broker with high commissions? That broker will be so grateful that he'll discover he has a whole bunch of office space uptown that he isn't using, already equipped with a bunch of Pentium Pros. He'd be delighted to allow his best customers at the Chump Fund to hang out rent-free.

In your naivete, you might call this a kickback but in the industry it is known as "soft money." Every time the Chump Fund trades with a broker, they accumulate some soft money that they can spend on computers, furniture, data feeds, etc. This comes on top of the opera tickets, broadway shows, limousines, and the rest of the Wall Street lifestyle that is paid for by Mr. and Mrs. Middleamerica.

If the Chump Fund keeps on doing this, eventually their return will be much lower than the S&P 500 and they won't be able to run those nice-looking advertisements anymore. What do they do? Look among the 20,000 tiny little mutual funds out there. Find one that has randomly achieved above-average performance for the past five years. Call it the Chump Growth and Income Fund and run ads showing its past performance. Send letters to all the old Chump Fund customers telling them that the Chump Fund is being closed and, unless they object, their investments will be rolled into the new Chump Growth and Income Fund as of September 1.

An even better strategy for a mutual fund company is to do all of this in-house. If they have 50 mutual funds they can just hang onto the ones that randomly do better than average and flush the ones that do noticeably worse. Then at any time they can show that "45 out of our 50 funds outperform the indices". Now you know why you can't find any mutual funds advertised in the Wall Street Journal that sport worse-than-average performance.

OK, so you expected to get cheated a bit by these Wall Street types. But they're experts so of course they will do a better job picking stocks, won't they? Some will. But with tens of thousands of mutual funds out there, even if they are all choosing stocks at random, you'd expect some to do consistently much better than average and some to do consistently much worse. You'd find, however, that most of them would fall in the middle, forming a Gaussian curve.

That's what Burton Malkiel expected to find. He was an economics professor at Princeton who made his life's work the study of investment. When he charted the performance of all the mutual funds, they did indeed form a bell curve. But the center was not the same as the S&P 500. It was shifted slightly to the left. That's right, the average mutual fund was underperforming the blind index by a couple of percentage points. This confused Malkiel until he realized that the discrepancy could be accounted for by the expenses skimmed off the top of the mutual funds and also the commissions they paid to trade the portfolio. [Note: these curves are published in Malkiel's excellent A Random Walk Down Wall Street, an essential book to read before investing.]