Is looking for mutual funds with above-average returns the best way to pick good ones? Not exactly. Think about it this way: You know that many mutual funds aren't too impressive. So, you look at lists of mutual funds and check their returns over the past few years. You invest only in the ones that have done well over the last year or several years, the ones that beat the market average. This sounds like a reasonable approach, but it's flawed.
Here are some things to muse on:
Funds that beat the market average one year are not necessarily likely to beat it the following year. To some degree, a terrific return isn't the result of the fund manager's brilliance but of good luck. (At least over the short term, and many fund managers invest only for the short term.) Most funds have occasional very good years.
Funds with a great three- or five- or even 10-year average often have that great average because of one amazing year. After all, a five-year average is just an average of five numbers. If one of them is unusually high, the average will be high. Let's consider an example. If in a five-year period a fund earns, respectively, 8%, 11%, 4%, 12%, and 33%, its average annual return will be about 13%. That might look respectable, but note that in reality it exceeded 13% in only one of five years. That 33% return (an "outlier" in statistical terms) has skewed the average. It might not be a problem if you were guaranteed 33% every five years, but that's not likely.
It might shock you to learn that in recent decades the vast majority of open-end equity funds underperformed the market average (as measured by the S&P 500 index) in the past five or 10 years. BusinessWeek magazine provided an excerpt from The Great Mutual Fund Trap, a book that explains why the odds are against your picking a fund that will beat the market.
So, what to do? Well, consider investing in an index fund. If you can't otherwise beat the market average, you can meet it (and outperform the great majority of other mutual funds) by investing in a market index fund. Many companies, such as Vanguard, offer these. We like funds that track the S&P 500 or the broader "total market."
Learn more about investing in mutual funds in our Mutual Fund area, and zero in on our index fund information there.
If you're interested in finding some of the few funds that do have a strong track record and are likely to beat the market, check out our new mutual fund newsletter, Motley Fool Champion Funds.