Finding the Right Mutual Funds

Approximately 80% of mutual funds underperform the average return of the stock market. How do you find a great one?

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We know you probably don't want to spend hours learning about the intricacies of mutual fund investing. Even if you've cleared your calendar for some quality fund study time, we don't need to dominate your afternoon with this topic. So, here are seven words that'll serve as the foundation -- heck, make that the foundation, walls, roof, and wall-to-wall shag -- for your long-term success in investing in mutual funds:

If in doubt, buy an index fund.

There you have it! Thankyouverymuch, ladies and gentleman! We're here every Friday. Please remember to tip your waiters and waitresses.

Still here? All right. You caught us trying to sneak out of work early on a sunny day. Mutual funds are a hot commodity with individual investors and financial institutions, with trillions of dollars invested in them.

With so much money riding on the success of mutual funds, how can we be so pat with our breezy summation? Well, the fact is that most investors can be perfectly comfortable buying an index fund -- which is simply a mutual fund that tracks some stock market index, whether it's the Standard & Poor's 500 Stock Index, the entire stock market index, or some other performance measure of a like group of stocks.

Before we get into that, first, a little background.

What are mutual funds?

A mutual fund is simply a collection of stocks and/or bonds. Mutual funds are financial intermediaries -- they are set up to receive your money and then make investments with the money. Most mutual funds are "actively managed," meaning the mutual fund shareholders, through a yearly fee, pay a mutual fund manager to actively buy and sell stocks or bonds within the fund. When you buy mutual fund shares, you are a shareholder -- an owner -- of that mutual fund, with voting rights in proportion to your ownership of the fund.

The price of "active management"

Though you would think that mutual funds provide benefits to shareholders by hiring "expert" stock pickers, the sad truth of the matter is that over time, the vast majority -- approximately 80% -- of mutual funds underperform the average return of the stock market.

Why the underperformance? The toughest job an active manager has to do is to overcome the higher costs of an actively managed fund. Many simply aren't up to the task.

What does this mean for you?

In simplest terms, you can't afford to pay for fund managers that don't earn their fees. If a fund has fees of 2% and only matches the market with its stock picks before paying those fees, then you'll end up with a return that's 2% less than the market's, year after year.

Although 2% may not sound like that big of a deal , it represents nearly a fifth of the market's long term average return of around 10%. Put another way, over 50 years, a $10,000 investment will compound to $1,170,000 at 10% returns per year, but to only $470,000 at 8% per year.

Uh-oh, now what?

You need to pick your funds carefully. For the most part, picking a fund is just like investing in individual stocks. You might be happy with an index fund. But what if your 401(k) doesn't offer an index fund? Or what if you already own an index fund but want to add some diversity to your portfolio? Or, perhaps you wonder: "I've heard plenty about mutual funds that beat the pants off your namby-pamby index fund. How do I get me one of those?"

Well, there are some funds -- or, more precisely, some fund managers -- whose services are worth paying for, because they are superior investors who are simultaneously fee-conscious. You just have to find them and know what the heck everyone is really talking about.

Pick a Winner!

All there is to picking the right mutual funds is learning what to look for. We offer some general guidelines, as well as some hands-on resources, to help you find winning funds for your portfolio:

  • If you don't have an index fund in your 401(k) or have a hankering for higher returns, head this way to find out how to pick the best mutual funds.
  • If you already own a mutual fund, there are some things that you need to think about before you dump a stinker fund. Even if you aren't selling, you need to do some regular maintenance -- rotate the tires, check the oil, manage your capital gains, etc. For a quick rundown, head here.
  • As you read our sacred words (ahem), don't get thrown by the jargon. Check out our mutual fundese translations.

As you make your way through the fund area, if you find yourself with questions, consider taking a look at our Motley Fool Champion Funds newsletter service. Our fund experts are here to help you, and a free trial gets you full access without any obligation to subscribe.