Don't Let a Little Underperformance Spook You

You probably know that most managed stock funds underperform the overall stock market. You can bypass that danger by investing in index funds. Or you can seek out the relatively few funds with above-average records and prospects.

So far, so good. But the thing is that even good funds don't have perfect records of outperforming all the time. According to research by the folks at the Brandes Institute, we should expect pretty much all good funds to slump for a while. They looked at the 10-year record of 76 global stock funds, divided them into deciles by performance, and found that all funds in the top group had at least one year when their returns put them among the worst performers. Still, they significantly beat the market in the long run.

The lesson to draw here is that when you're shopping for a great fund, don't be put off if you see one or two crummy years in its recent history. If it's a top-ranking fund now, don't be alarmed if it was rated much more poorly in the past, for a bit.

To test their findings a little, unscientifically, I looked up the records of a bunch of well-regarded funds with strong records. Just about all of them sported at least one underperforming year over the past decade, and some of these were whoppers. Here, see what I mean:

Data: Morningstar.
*Worst year measures number of percentage points the fund's return trailed the S&P's return. Data includes years since 2002.

See? In comparison to the S&P's loss over the past 10 years, these funds have all done spectacularly. But if you had bailed out on Yacktman after its subpar 2005 performance, you'd have missed out on its later success, including the current year, when it's beating the S&P by a staggering 32 percentage points.

So even if you think you're good at picking great mutual funds, expect occasional underperformance. In the long run, the best funds more than make up for their bad years.