Don't Say You Weren't Warned

With the so-called "lost decade" close in our rear view mirror, many investors feel like putting their money in index funds or ETFs that track the market just won't be good enough to secure a nice retirement.

And I can't totally blame you if you feel that way; it's certainly been a rough decade. But if you're thinking about placing your hard-earned cash in a mutual fund with the promise of crushing the market, let me explain why that's a bad idea -- and how you avoid making an enormous and costly mistake.

Not exactly what you signed up for
You see, managed mutual funds suffer from three specific ailments.

First, they can have insanely high fees. There's always an expense ratio, which charges you a percentage of your investment. But funds will often tack on a "management fee," a "12b-1" fee (which is basically a marketing fee), and sometimes even a "purchase fee" -- the fund charges you every time it purchases a stock! When you add all these fees up, it makes it almost impossible for you to generate enough returns to offset the extreme costs of doing business.

Second, actively managed mutual funds typically have very high turnover. This means that they are constantly buying and selling stocks; every time they do so, they incur a commission fee that ultimately gets passed onto you -- again, as a fee. Instead of buying and holding for the long term, managers often feel the pressure to buy turnaround stocks like Sirius XM Radio, and then dump them once they've secured a modest profit.

Third, mutual funds don't always offer you the diversification you think you might be getting. For instance, say you want diversified material exposure, so you invest in Materials Select Sector SPDR (XLB) -- but then you learn that nearly 20% of its holdings are concentrated in just two stocks, DuPont (NYSE: DD  ) and Dow Chemical (NYSE: DOW  ) .

Not only is this not the type of broad diversification you signed up for, but you'd also probably be better off owning these two companies separately. Both companies pay solid dividends above 2% and are trading for forward earnings multiples below 15 -- that's a pretty sweat deal.

Combined, these three reasons are probably why, historically, 80% of mutual funds underperform the stock market's return in a typical year. And now it seems as though we're continuing to flood the market with more and more capital -- not exactly a great sign for investors.

A much better alternative
Investors who actually want to beat the market need to be buying individual stocks. Discount brokerage firms like Charles Schwab have lowered their trading fees so dramatically that investing on your own is now a truly inexpensive option. Investing in stocks on your own means you don't have to put up with all sorts of ambiguous fees, which lowers your costs and ultimately will lead to great returns.

And because you're in charge, you aren't captive to high turnover rates, and you can actually be a buy-and-hold investor. Lastly, it also means that you can take charge of diversification, picking and choosing the stocks that you think will give you the best return for the least risk.

But picking stocks can be a daunting task -- that is, unless you know the right places to look.

Where to look
Start by looking for stocks with the following characteristics:

  • low price-to-earnings ratios
  • historical earnings growth
  • potential for future earnings growth
  • management you can trust

This will ensure you're buying a stock at a reasonable price, and that there's a good chance that company's value will increase over the long haul.

To get you started on this process, I ran a screen for exactly the attributes listed above: cheap valuation, past and future earnings growth, and a high return on equity to illustrate that management knows how to allocate capital. Here are four stocks that I felt really fit the bill:

Company

P/E Ratio

3-Year Earnings Growth

Next Year Projected
Earnings Growth

Return on Equity

Corning (NYSE: GLW  ) 9.3 18% 57% 20%
Trina Solar (NYSE: TSL  ) 12.0 104% 69% 25%
Freeport-McMoRan (NYSE: FCX  ) 12.7 14% 28% 41%
Veeco Instruments (Nasdaq: VECO  ) 14.0 116% 1,500% 30%

These stocks are all have great characteristics that deserve your attention -- and some more due diligence to see if they fit your investing style.

One stock that our Million Dollar Portfolio analysts really like right now is Activision Blizzard (Nasdaq: ATVI  ) , the leading video game publisher in the world. With a rock solid balance sheet ($2.8 billion in cash and no debt), an eclectic gaming backlog, and a diversified revenue stream, Activision Blizzard has a clear competitive advantage over its peers. Yet in the last six months, the stock has dropped by more than 10%, which caught the eye (and the recommendation!) of our Motley Fool analysts.

At Million Dollar Portfolio, our team looks for great companies that have solid balance sheets and seasoned management, and takes advantage of opportunities to buy when the market isn't feeling the same way we do.

If you need help finding the best stocks from our Motley Fool universe, Million Dollar Portfolio is a great place to start. To learn more about Activision Blizzard, or to see all of the service's past and present recommendations, click here for more information.

Jordan DiPietro owns shares of Activison Blizzard. Activision Blizzard and Charles Schwab are Motley Fool Stock Advisor selections. Motley Fool Options has recommended a synthetic long position on Activision Blizzard. The Fool owns shares of Activision Blizzard. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.

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  • Report this Comment On October 14, 2010, at 6:37 PM, AnthonyDuBon wrote:

    I want to offer a different opinion about the possibilities of performing above the market by investing in stocks and mutual funds. This article maintains that one needs to be in individual stocks to get that edge over the market.

    Actively managed mutual funds can provide the edge, but they need to be selected carefully. The best of them are superior "decision making machines." There is a very good rationale for positing that past performance can identify funds likely to outperform in the future. The best decision-making machines persistently make good decisions day after day, quarter after quarter and year after year. Their decision-making capability is the bottom line result of people, processes, approaches, and tools that they use every day to make decisions. Good machines are more likely to make good decisions than bad machines. This capability to make consistently good decisions can be inferred from past risk, return and persistence behavior. Persistence is the tendency of a fund to exceed S&P500 return at lower than S&P500 risk. You can learn more about mutual fund persistence at www.fundreveal.com

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