Best Buys Now

Perhaps you've heard that roughly three-quarters of all mutual funds lose to the market over the long run. The question is why -- why do presumably smart and talented managers serve you worse than simply buying an index fund? Believe me, I've met plenty of fund managers, and the vast majority of these folks are talented and responsible and hardworking. They're not bad stock pickers.

The best explanation I've found comes from a recent study by professors Cohen, Polk, and Silli. Their study, "Best Ideas," provides pretty convincing evidence that the rules are stacked against smart fund managers. Their few very best ideas do perform well -- beating the market and their other picks by approximately 1% to 4% per quarter (which is significant). However, the very nature of a mutual fund requires managers to pick dozens -- perhaps hundreds -- of stocks.

Who can pick 100 good stocks? No one, really ... and having to load up a fund's portfolio with all these second-tier ideas seriously harms returns.

But what if ...
The knowledge that fund managers' best ideas tend to outperform might be profitable for us individual investors if we knew with certainty which stocks they most loved. One proxy for determining a fund's favorite ideas might be to look at its largest holdings. Take, for example, Fidelity Contrafund (FCNTX), one of the largest funds in the world:

Fidelity Contrafund Top Holdings	% Net Assets
Google	5.15
Apple	4.44
Fidelity Cash Central Fund	4.44
Berkshire Hathaway A (NYSE: BRK-A  )	3.67
Wells Fargo (NYSE: WFC  )	3.61
Coca-Cola	2.28
McDonald's (NYSE: MCD  )	2.17
Gilead Sciences	1.92
Visa (NYSE: V  )	1.85
J.P. Morgan Chase	1.72
Qualcomm	1.51
Walt Disney (NYSE: DIS  )	1.51
Procter & Gamble (NYSE: PG  )	1.49
Johnson & Johnson (NYSE: JNJ  )	1.44
Abbott Labs	1.40

Data from Morningstar; holdings as of Aug. 31, 2009.

Google is its largest holding, but is it really fund manager William Danoff's very best stock idea right now? We can't really know unless we bug his meeting rooms. Maybe it is, or maybe Google just grew to be the largest holding. Perhaps Danoff has another great idea now that he's just starting to accumulate shares of -- and he's selling off Google to do so.

There's lag time in reporting fund holdings, and who knows which company is on top now? You no doubt see the problem here -- we don't want to commit our hard-earned money to a guessing game.

So now you know the big reason for mutual fund mediocrity, and there's just no getting around it.

Unless ...
There's something of a silver lining in this study, however. If you're an experienced and competent investor, you can take comfort in the fact that you're not bound by the mutual fund rules. You don't have to buy dozens and dozens of companies; you can limit your investments to your very best ideas.

Our internal research at Motley Fool Stock Advisor backs up the conclusion of the "Best Ideas" study. Even better, however, is that you don't have to guess what its best ideas really are. Fool co-founders David and Tom Gardner have been offering up their five "Best Buys Now" each month since June 2006. Our internal tracking shows that these ideas, like the fund managers' best ideas, significantly outperformed the other stocks on our scorecard -- by a margin of 7 percentage points per pick. (The service as a whole is beating the S&P 500 by an average of 47 percentage points each.)

Interested in the five best ideas from Tom and David right now? For the next 30 days you can see them, along with all their recommendations, with a no-obligation free trial. Here's more information.

This article was originally published on Aug. 19, 2009. It has been updated.

Rex Moore drives on a parkway and parks on a driveway. He owns shares of Berkshire Hathaway, Johnson & Johnson, and Procter & Gamble. Walt Disney and Berkshire Hathaway are Motley Fool Stock Advisor recommendations. Walt Disney is a Motley Fool Inside Value pick. Johnson & Johnson and Procter & Gamble are Motley Fool Income Investor picks. The Fool owns shares of Procter & Gamble. The Fool has a disclosure policy.