The problem with investing in the best mutual funds

The problem with investing only in the "best" funds

Note that according to studies, about 10 percent of all actively managed funds have beaten an index fund on an after-tax basis. Why not just find the top funds and invest all your money in them?

There are two reasons why investing in yesterday's winners may disappoint you. First, it may be plain dumb luck that allows a fund to perform well.

What if I told you about a stock fund that started in 1967, invested in 28 companies, and outperformed market averages and the vast majority of all mutual funds for the next 17 years. You'd think that the manager of the fund is a great stock picker, and you'd be more than willing to pay to get into that fund, right?

But what if I told you that the stocks in that portfolio were selected by editors at Forbes magazine who threw darts at a newspaper listing of stock prices. Your desire to pay a premium for the fund's investment genius probably would drop considerably.

The second reason why a fund might outperform market averages is because it takes on more risk. I discuss this more in my tape on stock investing, but you always can beat market averages by taking on more than average risk.

And you shouldn't pay a manager more just because she takes on more risk. If you want, you can amplify your risk and return simply by using borrowed money.

So don't be too impressed by a fund that beats market averages. It may just be dumb luck, or accepting more risk than the average.

Using the efficient market

So if the securities market in the United States is fairly efficient and most securities are priced accurately, what are the implications? Does this mean that you should just invest everything in an index fund and relax and go to the beach?

Well, you could, and you'd probably do better than most other investors. It's very difficult to beat market averages by even a few percent, but it's very easy to do worse by speculating and having everything blow up on you.

Still, even if you believe in the efficient market, you shouldn't just throw darts at mutual fund listings to select your investments because this might lead to a nondiversified portfolio. You should know how to diversify your money into a variety of different assets for maximum return with minimum risk.

So don't knock yourself out reading expensive newsletters and looking for the next great investment. If you feel like you really need to do more, either research for general information about investments, or better yet learn about our tax system.

Taxes can take a third or more of your investment earnings, so it will be very difficult to get ahead until you understand how to minimize your taxes through retirement accounts or other strategies. For more information on taxes, try my tape on income tax planning.

Why people try to beat the market - to make money!

So if the market is so efficient, why does almost everyone try to beat it? Pride is of course a big reason. Everyone thinks they're a little smarter than their peers, so of course they should be able to outperform the market by a little. Never mind that everyone thinks this, and by definition, not everyone can beat the average.

But there's also a very rational reason for trying to beat the averages. If you understand the power of compound growth, which I discuss in my tape on retirement planning, you know that slight increases in your average return will give you a lot more money over the long run.

It's also FUN to try to beat the market

But probably the biggest reason for trying to beat the market averages is because it's just plain fun.

So if you'd like to have fun and try to beat the market, go ahead, but I'd recommend that you also put a good portion of your money in an inexpensive index fund just in case your method doesn't work out too well.