Don't Say You Weren't Warned

This year got off to a slow start, with all major indexes off by about 3% in January. But that didn't stop investors from pouring into mutual funds, which had inflows of about $44.5 billion for that month.

In fact, by mid-March, U.S. equity funds and exchange-traded funds had experienced their seventh straight week of inflows -- the longest streak since 2004.

Let me tell you why this is an ominous sign for the investing community, and how you can avoid making some major mistakes in the decades to come.

Not exactly what you signed up for
You see, managed mutual funds suffer from three specific ailments.

First, they can have insanely high fees. There's always an expense ratio, which charges you a percentage of your investment. But funds will often tack on a "management fee," a "12b-1" fee (which is basically a marketing fee), and sometimes even a "purchase fee" -- the fund charges you every time it purchases a stock! When you add all these fees up, it makes it almost impossible for you to generate enough returns to offset the extreme costs of doing business.

Second, actively managed mutual funds typically have very high turnover. This means that they are constantly buying and selling stocks; every time they do so, they incur a commission fee that is ultimately passed onto you -- again, as a fee. Instead of buying and holding for the long term, managers often feel the pressure to buy turnaround stocks like Sirius XM Radio and then dump them once they've secured a modest profit.

Third, mutual funds don't always offer you the diversification you think you might be getting. For instance, say you want diversified energy exposure, so you invest in the Energy Select SPDR -- but then you learn that 30% of its holdings are concentrated in just two stocks, ExxonMobil and Chevron.

Not only is this not the type of broad diversification you signed up for, but you'd probably be better off owning these two companies separately. Both sport dividend yields above 2.5% and are trading for earnings multiples of less than 15. That's a pretty sweet deal.

Combined, these three reasons are probably why, historically, 80% of mutual funds underperform the stock market's return in a typical year. And now it seems as though we're continuing to flood the market with more and more capital -- not exactly a great sign for investors.

A much better alternative
Investors who actually want to beat the market need to be buying individual stocks. Discount brokerage firms like Charles Schwab have lowered their trading fees so much that investing on your own is now a truly inexpensive option. Investing in stocks on your own means you don't have to put up with all sorts of ambiguous fees, which lowers your costs and ultimately will lead to great returns.

And because you're in charge, you aren't captive to high turnover rates, and you can actually be a buy-and-hold investor. Lastly, it also means you can take charge of diversification, picking and choosing the stocks that you think will give you the best return for the least risk.

But picking stocks can be a daunting task -- that is, unless you know the right places to look.

Where to look
Start by looking for stocks with the following characteristics:

• low price-to-earnings ratios
• historical earnings growth
• potential for future earnings growth
• management you can trust

This will ensure you're buying a stock at a reasonable price, and that there's a good chance that company's value will increase over the long haul.

To get you started on this process, I ran a screen for exactly the attributes listed above: cheap valuation, past and future earnings growth, and a high return on equity to illustrate that management knows how to allocate capital. Here are five stocks that I felt really fit the bill:

These stocks are all have great characteristics that deserve your attention -- and some more due diligence to see if they fit your investing style.

One stock that our Motley Fool Stock Advisor analysts really like is Hasbro, the toy company that has come up with everything from Monopoly to G.I. Joe. It has been able to grow its revenue at an average of 6% a year for the past five years, and it has an excellent pipeline of products. It also sports a reasonable P/E ratio of 15.7, and analysts expect it to grow by at least 10% each year for the next five years.

Those qualities attracted our analysts at Motley Fool Stock Advisor, who recently recommended the toy company. If you need help getting started picking your own stocks, or if you're interested in learning more about Hasbro, you can see all the past and present recommendations from  David and Tom Gardner (who spearhead Stock Advisor), free for 30 days. Click here for more information.

This article was originally published March 29, 2010. It has been updated.

Jordan DiPietro owns shares of Hasbro and Apollo Group. Apollo Group is a Motley Fool Inside Value recommendation. Hasbro, Charles Schwab, and SINA are Stock Advisor selections. The Fool owns shares of Hasbro and has a disclosure policy.