When choosing a mutual fund, most investors give too much weight to past performance. This often leads to poor investing decisions, as the mutual fund suddenly goes from an all-star performer to a has-been. Then the dog mutual fund gets sold in disgust after a few years of underperformance, and the poor investor picks another highflier in hopes that it will continue its market-beating ways.

Raise your hand if that's happened to you. Yeah, I thought so. Past performance is rarely useful when evaluating a mutual fund manager's future chances of success. There's always a caveat, of course: A 10- or 20-plus-year track record of outperformance, like that of Legg Mason's Bill Miller, is probably a good indicator of outstanding management. However, that tends to be the exception, not the norm.

Shannon Zimmerman, our resident mutual fund expert, knows how difficult it can be to find good mutual funds. Yet his Motley Fool Champion Funds newsletter service is soundly crushing the market with picks like Dodge & Cox International with top holdings that include Sanofi-Aventis (NYSE:SNY), Sony (NYSE:SNE), and News Corp. (NYSE:NWS). And that's because Shannon knows that past performance isn't the best or only way to find excellent performers. Statistically, anywhere from 75% to 90% of managed mutual funds fail to beat the market over 10 years or more. To find funds guided by excellent managers that will outperform in the long term, we need more information.

Four rules to live by
Rather than rehash all of the endless details of the many studies on mutual fund managers' performance, here are some key takeaways for the individual investor:

  1. No one fund style outperforms the others. A high-flying value fund can nosedive just as quickly as a high-flying growth fund.
  2. Using a time period of five years or less to evaluate performance is a bad idea. We cannot tell whether the fund is succeeding because of managerial skill or the simple luck of investing in the right sector at the right time.
  3. Proper benchmarking is key. Comparing a micro-cap fund to the S&P 500 index is not a fair comparison, considering the level of risk in each. After all, is it really fair to stack giants like Bank of America (NYSE:BAC) and ExxonMobil (NYSE:XOM), with their $200 and $300 billion-dollar-plus market caps, against micro caps like ADAM (NASDAQ:ADAM) and Prospect Energy (NASDAQ:PSEC), with market caps that barely crack $50 and $100 million? Let's be rational.
  4. The amount of money managed affects returns. When assets under management grow past the $5 billion mark, managers must choose from a more limited universe of large-cap stocks for their portfolios.

Luckily, many websites such as Morningstar or Yahoo! compare mutual funds to the appropriate benchmarks over long periods of time and list the fund's asset size. The information is out there, and we as investors need to utilize it and move away from relying too much on past performance as our guide.

How can I outperform a dart-throwing monkey?
Most of the best long-term mutual fund managers regularly underperform the indexes on a one- to five-year basis. If you judge funds only by past performance, you might miss some of the best managers in the business. Instead, try analyzing the fund manager's processes and stock-selection process. For example, if the manager has recently switched from a small-cap to a large-cap focus -- a size shift -- the outstanding performance record obtained with small-cap stocks may become moot.

One of the best ways to decide whether managers are right for your portfolio is to read their annual letters to get an idea of how they choose stocks. (Many managers discuss their current holdings in detail.) In addition, you can search online for recent interviews that may lend insight into the manager's strategy. The turnover ratio also indicates a manager's quality; unless that manager is specifically pursuing a frequent trading policy, lower turnover generally indicates a manager's greater confidence and often points toward long-term outperformance. Any turnover ratio under 100%, indicating that at least some of the portfolio's holdings have stayed put for one year, is a favorable indicator.

When past performance does count
In the long term, past performance can be a good judge of a fund's potential when:

  • The record is made up of many decisions in different market environments.
  • An appropriate benchmark is used.
  • The same managers have run the fund during the entire time frame, and/or the managers have an excellent track record from prior funds.

Although you shouldn't rely on it entirely, don't ignore past performance altogether. As investors, we should consider past performance during good markets and bad, and always compare results to the proper index. In my opinion, this is where Shannon Zimmerman adds real value at Champion Funds; past performance is only one part of his plan. You can see for yourself with a 30-day guest pass.

In selecting a mutual fund, please be careful in how you use past performance. It's like a drug: easily accessible, addictive, but ultimately bad for your investing health.

This article was originally published on March 31, 2006. It has been updated.

Fool contributor Stephen Ellis welcomes your feedback. He was once addicted to using past performance to evaluate mutual funds, but a 12-step program helped him kick the habit. Stephen does not own shares in any companies mentioned. Bank of America is an Income Investor recommendation. The Fool has a time-testeddisclosure policy.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.