Don't Buy These Top-Performing Investments

After the carnage we endured in the market last year, investors are eager to get their portfolios and their dreams of retirement back on track. Unfortunately, if history is any guide, many of them will go about it exactly the wrong way -- by chasing performance.

While it may seem like an easy fix to identify which stocks or segments of the market have been outperforming lately, and throw your money at them in the hopes that they'll continue their winning ways, this is a surefire way of sandbagging your portfolio.

Chasing one's tail
Let's examine which investments have landed at the top of the charts so far in 2009. According to the Morningstar Principia database, the following five funds are all near the top of the class:

*Performance year to date through June 30, 2009.

Wow! Those are some pretty hefty returns. But before you go imagining ways to fit one of these highfliers into your portfolio, take a closer look at each of these funds. You'll find several reasons why they aren't appropriate for most investors.

First of all, the two ProFunds offerings and the Direxion exchange-traded fund are leveraged funds, which offer investors a multiple of the index that the funds are tracking. The ProFunds offer 150% and 200% of their respective indexes, while the Direxion fund offers 300% of the daily return of the MSCI Emerging Markets Index! To me, that sounds more like gambling than investing.

In addition, most of these options are very narrowly focused, investing in just one industry or one emerging economy, like JP Morgan Russia. It's no surprise that funds like these land at the top of the performance charts -- they're also the most likely to land at the bottom of the charts next year.

These risky, narrow funds are highly volatile. In fact, of the four of these funds that were in existence in 2008, each of them lost between 61% and 89% last year alone! Most investors don't have any need for narrowly focused investments like these. Fools should stick to well-diversified, broad-market options instead.

While the Dreyfus fund invests more broadly across emerging markets, it is highly concentrated, with more than 79% of assets in just three sectors, and 55% allocated to two countries. That means concentrated bets, which could sink the fund if they don't pan out. Furthermore, the fund is relatively new, with less than two years of a track record. That's a bit too soon to make a solid judgment call on the managers' long-term skills.

Lastly, as is typically the case with highly specialized funds, each of these top performers is ridiculously expensive. Whereas the average mutual fund sports a 1.3% net expense ratio, these chart-toppers range in price from 1.66% to 2%. The Direxion ETF is slightly cheaper at 0.75%, but that's still much higher than the cost of the average exchange-traded fund! That's more than any investor should be willing to pay for the privilege of owning any fund, no matter how outsized the gains may be in any short-term period.

The cost of folly
While it can be incredibly tempting to chase returns, keeping a steady head as trends come and go is one of the key attributes of successful long-term investors. In fact, a study performed by the Financial Research Corp. (FRC) found that on a rolling return basis from January 1990 through March 2000, the average mutual fund's mean three-year return was 10.92%, while the average fund investor gained only 8.7% over the same period. The study attributes the difference to investors' habit of chasing performance, as measured by rising redemption rates and shorter holding periods.

A better way
So what does this all mean? Well, first of all, if you want to win at the investment game, you've got to move beyond short-term thinking. A longer-term, buy-and-hold focus is essential. You've got to look past the temporary ups and downs of the market and keep the long-run trajectory in mind.

Secondly, if you're shopping for mutual funds, make sure you're not using past performance as your sole criteria for selection. While it is perfectly OK to take longer-term performance into account, I would argue that it's more important to first find a fund with an experienced, long-tenured manager, low expenses, a consistent investment history, and solid performance in both good and bad environments. Once you've done that, see how it stacks up against its competitors' track records.

If exchange-traded funds tickle your fancy, make sure you stick to broad-market, well-diversified options like Spiders (NYSE: SPY), PowerShares QQQ Trust, or Vanguard Total World Stock Index (NYSE: VT). And whatever you do, make sure you're not overpaying for ETFs -- buy the cheapest funds you can find that get the job done.

Of course, if you consider yourself a stock jockey, there's no better place to get investment ideas than from some of the brightest names in the business. For example, top manager Chris Davis of Selected American Shares (SLADX) is loading up on information technology picks like Activision Blizzard (Nasdaq: ATVI) and Hewlett-Packard (NYSE: HPQ), as well as health-care names like Pfizer (NYSE: PFE) and Becton, Dickinson and Company (NYSE: BDX).

To get more of the inside scoop on how to invest your retirement-minded dollars, be sure to check out the Fool's Rule Your Retirement service. With your free 30-day trial, you will get access to a wealth of insider tips and hints to meet your retirement goals with plenty of room to spare.

There are worthwhile ways of rebuilding your portfolio, but chasing performance isn't one of them. By choosing the right investments and sticking with them for the long run, you'll be ahead of the pack, instead of chasing others.

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This article was originally published June 18, 2009. It has been updated.

Amanda Kish heads up the Fool's Champion Funds newsletter service. Pfizer is a Motley Fool Inside Value recommendation. Activision is a Stock Advisor choice. The Fool's disclosure policy can't decide whether it'd rather be the chaser or the chasee.