One investing hero is John Bogle, known as the father of index funds. He's an eloquent thinker and writer, one who takes on the establishment by making important points.

He's also a fine speaker. In a speech from 2003, titled "How the Mutual Fund Scandals Will Serve Fund Owners," Bogle offered some statistics that made people sit up and take notice. Get a load of this:

From 1984 to 2002, the S&P 500 (which reflects most of the U.S. stock market) averaged an annual return of 12.2%. Mutual funds, meanwhile, averaged a 9.3% return. And individual mutual fund investors like you and me? Well, on average, we earned ... 2.6%.

You read that right. Not only did funds, in general, underperform, but individuals underperformed the funds. And by quite a bit, too. This is perplexing, because even though the market hasn't done nearly as well since 2002, many stocks have managed to beat that 2.6% figure. For example:

Company

Average Annual Return, 2002-2009

Deere (NYSE:DE)

11.4%

Diageo (NYSE:DEO)

5.6%

General Mills (NYSE:GIS)

5.5%

Genzyme (NASDAQ:GENZ)

9.7%

TJX (NYSE:TJX)

6.7%

Intuitive Surgical (NASDAQ:ISRG)

37.4%

AutoZone (NYSE:AZO)

9.3%

Data: Yahoo! Finance.

Why funds falter
It's probably not a surprise to you that most funds underperformed. We at The Motley Fool have been crowing about this for more than a decade, urging investors to seek out only the best mutual funds.

But why do most funds underperform? Well, there are several explanations:

  • Fees. Bogle pointed to these as a main culprit. Managed stock funds often sport expense ratios (which are annual fees) well above 1%, and on top of that there are often other fees, such as sales loads. If the funds otherwise would have met the market average, once you remove the fees, they would have underperformed.
  • A short-term focus among fund managers can also be blamed. Many managers feel pressured to deliver strong results each quarter. That's just not reasonable, because both good stocks and the overall market will rise and fall from time to time. Trying to guess the timing will lead to many suboptimal decisions.
  • Another reason to frown at many funds is frequent trading. That can lead to greater tax hits (from short-term gains, versus long-term ones) and commission costs.

How individuals err
So we've explained away the fund performance. But how could the average fund investor end up with such lousy returns, when they're investing in funds with higher averages? The answer to this: our brains.

We investors, whether we're in stocks or funds, tend to make all kinds of irrational decisions, taking too much risk during good times and panicking when stocks fall. Some common blunders we commit include:

  • We don't follow Warren Buffett's advice: to be fearful when others are greedy and greedy when others are fearful. Instead, we tend to sell when the going gets tough (that is, when stocks are down, and therefore on sale) and to buy when the market is booming -- possibly near a high point, from which it will fall.
  • We are impulsive. We may, for example, jump into a stock or a mutual fund just because it has done very well in the past -- even just in the past year. Well, that doesn't mean it will do so well again. Lots of funds have one anomalous, amazing year -- and that can be enough to attract excited and naive investors.
  • Think about how the market achieves its long-term average return: by sitting there, with all its holdings in place, for a long time. It's when we jump in and out of stocks, trying to time the market, that we end up missing some important market advances.

What to do
So what should you do? Well, when you invest in mutual funds, be sure to look for ones with great long-term records and managers you trust. If you just stick with a good fund, you'll prevent yourself from short-circuiting your returns. There's no easier way to improve your results.

For more on smart fund investing:

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This article was originally published on Aug. 6, 2008. It has been updated by Dan Caplinger, who doesn't own shares of the companies mentioned. Intuitive Surgical is a Motley Fool Rule Breakers pick. Diageo is a Motley Fool Income Investor selection. Try our investing newsletters free for 30 days. The Motley Fool is Fools writing for Fools.