One Way to Beat the Market

Chances are, you've run across advice like the following many times:

• Invest in a broad-market index fund, such as one based on the S&P 500, and you'll earn the market's return, which has averaged around 10% over many decades.
• Aim higher than that by carefully choosing some managed mutual funds, because a relatively small number of them will beat the market.
• Aim even higher than that by investing in some carefully selected individual stocks, because they have the potential to far outstrip mutual funds.

It's all true, and I've even offered that same advice myself, many times. I have a nagging worry, though, when I offer it. I worry that people might look at these three options and decide to skip managed funds.

And that would be a mistake.

Funds can be powerful
In fact, a number of managed funds sport performances superior to many well-respected stocks.

Here -- check out the 10-year average returns for some well-known names in the S&P 500 (remembering that during this period, the S&P 500 itself averaged a 2.2% annual loss):

Data: Morningstar.com as of May 8, 2009.

Even Cisco Systems (NASDAQ:CSCO), which many of us are used to thinking of as an aggressive highflier, posted a 10-year average loss greater than the S&P 500's.

Meanwhile, check out the performance of these mutual funds:

Data: Morningstar.com as of May 8, 2009.

This is not to say that select individual stocks haven't outperformed select mutual funds -- they have and they will continue to. But it is to say that you don't have to rely only on individual stocks to significantly outperform the market.

It's just a matter of finding the outstanding funds.

Finding funds
You can find terrific funds by focusing on a few key criteria:

• Market-beating long-term track records.
• Low annual fees (ideally around 1% or lower).
• Managers that have been at the helm for a good while (a strong 10-year record with a short-term manager doesn't tell you much about the likelihood of outperformance going forward.

To know whether a fund is right for you, however, you have to know if the manager has a strong philosophy you're comfortable investing with. You can get familiar with a fund manager's thinking by looking up interviews, commentaries, and quarterly reports.

For example, Meridian Value fund manager James England Jr., explained in an interview that, "The investment philosophy of the firm is based on five principles. In the long term, stocks will outperform other liquid investments. Earnings growth is the most important determinant of stock prices. Valuation must be considered when investing in stocks. Firsthand research is critical. And, finally, investors should have at least a three-year investment horizon."

That's a philosophy I can get behind.

Get help if you want it
So go ahead and seek the best returns you can find, whether by funds, stocks, or a combination. Remember that there's no shame in taking the no-work approach and sticking with a market-matching index fund. But if you want to aim higher, look for some promising funds.

The criteria above should help get you started, but if you don't have the time to search out interviews with fund managers and other data, check out our Motley Fool Champion Funds investment service, which provides monthly recommendations of funds we think will outperform the market handily. Just click here to try it free for 30 days -- there's no obligation to subscribe.

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Longtime Fool contributor Selena Maranjian owns shares of Microsoft. Intel and Microsoft are Motley Fool Inside Value picks. Amazon.com and Marvel Entertainment are Stock Advisor recommendations. The Motley Fool sold puts on Intel. The Motley Fool is Fools writing for Fools.