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The Costly Mistakes Fund Investors Make

Mutual funds have offered investors great returns over the past 25 years. Yet even among those who've invested in stock funds, the average fund investor has earned only a small fraction of the market's return.

As it turns out, there are two reasons why mutual fund investors have gotten the short end of the stick in their total return, and you might be surprised at which one does more damage to your portfolio.

The cost of active management
You'll find plenty of data showing that index funds have outperformed their active counterparts over longer periods of time. For instance, according to Vanguard, stock index funds have outperformed about two-thirds of actively managed equity funds. Bond indexes have done even better, beating nearly 90% of active funds.

One study cited in The Motley Fool's Champion Funds newsletter discusses an even sharper contrast. While stocks earned 12.2% annually from 1984 to 2002, the average equity fund had a return of just 9.3%. Thanks to compounding, that 2.9% difference cost investors nearly half of their profits over the period.

Bad decisions cost more
Yet even more shocking is how much worse the average investor's fund returns were. Over the same period, the average fund investor earned just 2.7% annually. Put into perspective, that means most fund investors would've been better off just putting their money into a money market fund for 18 years.

What's behind this terrible performance? Investors made several mistakes that hurt their portfolios. Perhaps the biggest is chasing past performance. If you don't spend much time investing, you're more likely to hear about funds that have had outstanding performance recently. By the time you've heard about them, though, you've already missed out on a big part of their gains. And often, the funds that do best are among the worst performers when the markets turn around.

For instance, from 1998 to 2000, Fidelity Select Software (FSCSX) took advantage of the performances of Oracle (Nasdaq: ORCL  ) , Sun Microsystems (Nasdaq: JAVA  ) , and VeriSign (Nasdaq: VRSN  ) to triple in value. Yet by the middle of 2002, the fund had lost nearly all of its gains from the earlier period.

Now, many of the top-performing funds sport emerging-markets stocks like (Nasdaq: BIDU  ) , Petroleo Brasileiro (NYSE: PBR  ) , and China Mobile (NYSE: CHL  ) . Those triple-digit returns over the past year or two may be tempting, but they're unlikely to continue. Already this year, many emerging-markets funds are down 10% or more.

What to do
Luckily, solving the problem of underperformance is simple. Find funds that you can hold for the long term, and then hang onto those shares. This month's issue of Champion Funds, which is available online at 4 p.m. ET today, can help. Don't give in to the temptation of the latest big investing craze, because by the time you hear about it, it will have already run much of its course.

For more on smart fund investing, read about:

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