There are many dangers in investing -- such as the hot stock tip whispered to you by a colleague on a coffee break. One danger is the list of top-performing mutual funds that you'll find often in many financial periodicals. Why are such lists problematic? Let us count the ways:
Short attention spans
For starters, they often focus on very short time frames -- say, for example, top fund performers over the past six months. That's close to meaningless, because the stock market's moves are very unpredictable over short periods. Just as a blind squirrel will find an acorn now and then, subpar mutual funds will also occasionally have one blockbuster year. When that happens, the fund shoots to the top of various lists -- often for the only time in its life.
Then there's change. There are more than 8,000 mutual funds out there. Many of the funds at the top of one list will not be around the next time it's published.
Finally, there are all those devilish fund details that can sink individual investors. For example, I got the idea for this piece when perusing an issue of Consumer Reports Money Adviser, which featured a list of 25 top funds. No. 1 -- Vanguard Health Care -- has a minimum initial investment of $25,000, effectively locking out many of us. Nos. 2 and 3, Dodge & Cox Stock (FUND: DODGX) and Fidelity Low-Priced Stock, are already closed.
That list wasn't too helpful.
Finding funds
So how do you look for a good mutual fund?
For most people, we recommend index funds -- they're simple and save you the trouble of studying and selecting actively managed funds. By getting in on an index tracker such as Vanguard Total Stock Market (AMEX: VTI), you give your portfolio exposure to a wide range of market opportunities. That particular Vanguard fund holds approximately 5,000 positions, including small amounts of blue-chip giants Microsoft (Nasdaq: MSFT), Verizon (NYSE: VZ), Johnson & Johnson (NYSE: JNJ), and Altria (NYSE: MO). And as you'd expect, it offers incredible diversification. The fund's largest position, ExxonMobil (NYSE: XOM), represents just 2.7% of the total portfolio.
But if you want to do better than index funds, take some time to learn more. There are a lot of way-above-average actively managed funds out there.
Seek the champs
In looking, examine the managers' philosophy, tenure, and track record, as well as expense fees, tax efficiency, and minimum investment amounts. These are all important -- and are considered by our mutual fund analyst Shannon Zimmerman when he recommends index-beating funds in our Motley Fool Champion Funds newsletter.
Quality of management is a difficult factor to quantify. Yet if you want to be a successful fund investor, you should be particularly diligent about choosing fund managers and their strategies. Shannon rates managers in his newsletter using his "X" factor, taking into account past performance and strategic credibility.
If all of this sounds like you'd like some help getting started, consider taking a free 30-day trial of Champion Funds. Shannon has built three model portfolios for investors and has recommended more than 30 great funds that are beating their indexes by an average of 6 percentage points. And with all that, there's no obligation to subscribe.
This article was originally published on Dec. 9, 2004. It has been updated.
Longtime Fool contributor Selena Maranjian owns shares of Dodge & Cox Stock, Microsoft, and Johnson & Johnson. The Fool has a disclosure policy.
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