The good, the bad and the ugly

We're not mind readers, but our guess is that you clicked here looking for answers to two main questions:

Q: Are mutual funds a good investment? And,
Q: Which ones should I pick?

Without mincing words, here are our answers:

A: Some are. And,
A: The one that consistently outperforms all the others.

We're not trying to be cheeky. (OK, you caught us, we are.) It's just that the world of mutual fund performance is more complex than any 14-syllable answer that we could offer. The last time we checked there were more than 8,000 mutual funds from which to choose. And there's no shortage of bold-faced statements touting them. Advertisements in newspapers flaunt a fund's "five-star" status. Banner ads brag about "the NUMBER ONE FUND in America" and commercials hype "38.8% returns over the last six months."

It seems there are thousands of funds out there that have done really, really well. Just choose one, already!

What? You want more than seven words in bold type on a blinking banner to make sure you're making the right investment?

Good for you. The sad fact is that the vast majority of mutual funds underperform the average return of the stock market. And they are multiplying as fast as Tribbles on the Enterprise. It's not that they pick bad stocks; it's that they don't pick stocks well enough to compensate for the costs of the fund. The stock market's historical returns are roughly 11% per year, but managed mutual fund shareholders as a group can expect to see any return reduced by the costs imposed by the funds. For more on what's wrong with mutual funds, see our aptly titled article in this area: What's Wrong With Mutual Funds?

If the bite of fees weren't bad enough, there are four other pitfalls mutual fund investors have to watch out for:

• The Wisdom of Professional Management. This is not necessarily an advantage. Many mutual fund managers have proven no better at picking stocks than the average nonprofessional, but charge fees as though they are.
• No control. Unlike picking your own individual stocks, a mutual fund puts you in the passenger seat of somebody else's car.
• Dilution. Mutual funds generally have so many holdings by necessity that insanely great performance by a fund's best ideas doesn't make much of a difference in a mutual fund's total performance.
• Buried costs. Many mutual funds specialize in burying their costs and in hiring salespeople who do not make those costs clear to their clients.

Ready for some good news? Thought so. We promise there's some on the next page.