How You Got Snookered by Bad Investments

Given how badly the market has performed over the past 18 months, no one can really be surprised if they've seen their net worth shrink since late 2007. But what should surprise them is just how little protection many of them got from the managers with whom they entrusted their hard-earned money.

The Wall Street Journal recently reported on how actively managed mutual funds have performed relative to passive index funds. Unfortunately, the news wasn't good: Active stock funds lost an average of 47.6% since October 2007, while stock index funds lost an average of 47.8%.

Missing the big pitch
So why is that such bad news? After all, the results do seem to indicate that active funds more than managed to make up their higher-fee disadvantage to post a slightly less severe loss (assuming that the study took fees into account).

But active fund shareholders had hoped for so much better. Many investors pay for professional money management for one reason: They hope that their managers will find ways to cut their losses during a bear market. If a money manager could actually save you from the full brunt of a 40%-50% loss while keeping all the upside of stocks during bull markets, then paying an annual fee of 1%-2% might be well worth it.

When the best that active managers as a whole can do is a puny 0.2-percentage-point win, however, those hopes have evaporated. As disappointing as that is, it could have a silver lining -- if it pushes you toward finding the best fund choices out there.

Finding fund winners
With thousands of mutual funds to pick from, finding the best ones often seems like searching for a needle in a haystack. The best performers in one year often turn out to be the worst ones in following years.

For instance, take a look at some of 2007's great-performing funds -- and how they did in 2008:

Source: Morningstar.

You simply cannot look solely at short-term performance to predict which funds will do well in the future. So what do you look at?

3 winning traits
At our mutual fund newsletter, Motley Fool Champion Funds, lead advisor Amanda Kish looks for three basic traits of good managers.

First, you want someone who's consistent. Does the fund stick with a proven winning investment philosophy in good times and bad, or does it simply follow the trends and aim itself at investors seeking out the latest investing fad? You want a manager you can count on, not a chameleon who'll be completely unpredictable.

Second, managers with a lot of experience always trump the new kid on the block. You don't want anyone getting on-the-job training with your money -- especially during the most severe bear market in at least a generation.

Lastly, look at performance -- but not just over the past year or two. In fact, even managers who've done fairly badly recently could be great performers over the long haul. Look for consistent outperformance, and you may find the best funds.

If you find managers who have all three of those traits, then they may bring you the best chance for higher returns over time. In contrast, if you find that your funds lack some of these desirable attributes, don't panic -- but strongly consider looking for a fund that matches your wishes more closely.

Look forward
As disappointing as the markets have been lately, don't get hung up looking at the past. All you can do is learn from your mistakes and make the best decisions going forward that you can. If the losses you've suffered during the bear market motivate you to find better investments, then you may end up well ahead in the long run.

For more on smart mutual fund investing, read about:

• How you can rescue your 401(k) today.
• How wealthy investors are handling the bear market.
• Has the market hit bottom yet?