Personal Finance: How to pick a mutual fund

Next month something very dramatic is going to happen to most stock mutual funds. In fact, it's already started to happen.

The dramatic event is this: Those funds will hit the three-year anniversary of the nadir of the market in March 2009. And that means their three-year-return numbers will start to look amazingly good.

Think I'm being hyperbolic? The most widely held mutual fund -- the Vanguard Total Stock Market Index Fund -- is up at an annual rate of 30.23 percent from March 6, 2009, (the trough, by some measurements) through the end of last month, Jan. 31.

Dial those numbers back by six months -- from before the 2008 decline to before the big 2012 gains -- and the average annual returns for the same fund are 0.91 percent for the three-year period between Aug. 29, 2008 and Aug. 30, 2011.

"I'd be cautious about taking these new three-year annualized returns and saying: 'Wow, this fund is great!' " says Tom Roseen, an analyst with mutual fund research firm Lipper, a Thomson Reuters company. Another example: The widely held Vanguard Index Trust 500 Index Fund is up 28.66 percent from the trough through the end of last month, but up only 0.3 percent for the three-year period ending Aug. 30, 2011.

So, buyer beware. Roseen says there are several take-aways from these numbers. Here are a few.

Past performance really doesn't guarantee future results. Mutual fund investors are used to seeing those words, but it's hard to imagine a better illustration of how true they are.

Lots of people missed out. Who wins in the stock market now? "Those with the fortitude to be contrarian," Roseen says. "If you're doing what makes you uncomfortable, you're probably right." To earn money in a stock market like this, you don't really have to be trading wildly; you just have to stick with a plan.

People who stolidly kept putting money into the market (say, through weekly retirement plan contributions) despite the declines, and then rebalanced regularly, probably did even better than these averages, he said.

Don't buy mutual funds on the basis of one performance number or another. If you are shopping for a new fund, say to fill a hole in your retirement plan or other portfolio, first make sure that it has the right kinds of securities and objectives to actually fill that hole. Look at fund fees and make sure the amount you might be paying for outsized performance doesn't eat it all up.

Diversification lives. The main lesson to be learned and relearned is that it's good to figure out the right mix of several investments -- stocks, bonds, foreign holdings -- for your objectives and then stick with that mix.