Quick: What's the investment vehicle of choice for more than 90 million Americans?

If you said "mutual funds," give yourself a gold star and head to the front of the cubicle.

Here's another quick one: Are funds so popular because, to pick up on our headline, they're the best investment vehicles ever?

Peaceful, easy feeling
To my way of thinking, the answer is yes -- or, more precisely, they can be.

The kinds of funds worth building your portfolio around make it a cinch to spread your bets across buttoned-down big boys such as Procter & Gamble (NYSE:PG), Caterpillar (NYSE:CAT), and Wal-Mart (NYSE:WMT) -- long-haul market-beaters all.

The best also include racier fare such as MEMC Electronic Materials (NYSE:WFR) and GameStop (NYSE:GME). Both of those growth stocks come with above-average P/Es and projected growth rates in excess of 20%, as does Riverbed Technology (NASDAQ:RVBD), another go-go contender.

If you're looking for a no-brainer solution, funds make that a breeze, too -- and you won't have to pay up for the privilege, either. SPDRs (SPY), the S&P 500-tracking exchange-traded fund, sports an expense ratio of just 0.08%. Vanguard 500 (VFINX), a traditional mutual fund that also tracks the S&P, costs just 0.15%.

Here's the upshot, then: Well-chosen funds make light work of building a carefully calibrated portfolio. They're also the most convenient vehicles for investing in asset classes that may lie outside your "circle of competence," which is generally a good idea. Doing so can allow you to sleep peacefully at night, secure in the knowledge that folks who do understand, say, emerging markets and high-yield bonds, are busy building your nest egg.

Reality bites
That said, when it comes to investing, mere convenience isn't enough. And while I'm a fund fan, I'm also a realist -- funds are also popular because they're ubiquitous. 401(k) plans, after all, are lousy with them -- with an emphasis on the "lousy." That goes double for the industry's typical entrant, a fund that likely requires shareholders to pay for the privilege of underperformance.

How do you separate the keepers from the duds in your plans -- or your brokerage's? Keep the following points in mind, and you'll go a long way toward doing just that:

  • With funds, you're really investing in the manager. Don't focus on past performance unless that track record belongs to the person who's currently calling the fund's shots.
  • Look for low price tags. With funds, the price you pay is a feature of the "product" itself. The more you pay, the worse your performance will be; the less you pay, the more cash you'll have compounding, as opposed to fattening the fund company's coffers.
  • Last but not least, favor funds with proven strategies and managers who "eat their own cooking" by investing their own moola alongside that of their shareholders.

The Foolish bottom line
We've been using these core criteria since Day 1 at the Fool's Champion Funds investing service, and the strategy has found picks that consistently beat their benchmarks.

It's old-fashioned common sense, and you can put the same wisdom to work in your portfolio. If you'd like to see how we do it at Champion Funds, click here for a risk-free guest pass. You'll have access to our recommendations list, model portfolios, and a special report that provides step-by-step assistance for making the most of your 401(k) plan. There's no obligation to subscribe.

This is adapted from a Shannon Zimmerman article originally published on June 20, 2007. It has been updated.

Rich Greifner  does not own any of the companies mentioned in this article. The Motley Fool owns shares of SPDRs. Wal-Mart is an Inside Value recommendation. GameStop is a Stock Advisor selection. The Fool has the best. Disclosure policy. Ever.