When you're looking for good mutual funds, don't go into your hunt thinking you should seek out only the ones with above-average returns. For most funds, good performance is sporadic. But 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 rather of good luck -- at least over the short term. And many fund managers invest only for the short term.
What's more, 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 that -- an average of five numbers. If one of them is unusually high, the average will be higher. If, in a five-year period, a fund earns 8%, 11%, 4%, 12%, and 33%, its average annual return will be about 13%. That might look respectable, but in reality, it exceeded 13% in only one of those 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) over the past the five or 10 years.
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 vast 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 via our Motley Fool Champion Funds newsletter. Try it for free, and see which funds our analyst Shannon Zimmerman has recommended -- and why.
Learn much more in these articles from Shannon Zimmerman:
