A Suze Orman exclusive

Track Record
This is where most investors trip up and make some very costly mistakes. It is perfectly natural to want to size up a fund’s performance, but the problem is that investors tend to be ridiculously short-sighted. You get all excited about a fund that topped the performance charts for the past month, or year, rather than looking at what is really important: does the index fund, or its manager, have a long-term history of doing well?

The only performance figures you should ever pay attention to are the three-year, five-year, and, if possible, the 10-year numbers. Funds are a long-term investment, so you want to hook up with a portfolio (and manager) who has shown an ability to make money over years, not weeks. The inevitable list of hottest funds for the year is for suckers who want to chase the hottest hand. I would only invest in a short-term hot fund if it also has a strong long-term record too.

When sizing up a fund’s performance you want to see how it rates relative to other funds with a similar investment approach. This is where those fund categories come in handy: if you are sizing up a large-cap fund, you want to know how it has done relative to other large-cap funds.

When you check out a fund at Yahoo (just enter the five-letter ticker symbol), click on the Performance link on the left side of the page. There’s a ton of great info right there; you can see the longer-term performance of the fund, and how that rates compared to its category average. And be sure to scroll down to the annual return numbers. One problem with the long-term average annual returns is that they can mask a lot of volatility: a fund with a great three-year average return could in fact have had one phenomenal year and two just so-so years. Looking at the actual annual returns gives you a sense of whether a fund consistently outperforms its peers—or just gets lucky once in a while.

And at the bottom of that page is a fund’s rank within its category. Ideally you want a fund that consistently ranks in the top 40 or 50 percent of its category class over the longer time periods. Notice I didn’t say the top 10 percent. That’s too high a bar to set. You will do plenty well if your fund has the ability to stay in the top half of its class; it’s simply unrealistic to expect that it should always be right at the front of the line.

If you go with an actively managed fund, rather than an index, you also want to check out how long the current manager has been running the show. If a fund with a great five-year record has a manager who has been at the helm for just one year, you need to be cautious. That doesn’t mean you shouldn’t invest in the fund; rather, you just need to dig a bit deeper. Who’s the new manager? Someone with a great track record at another fund? Or someone who was an assistant to the lead manager for a bunch of years? Or is it someone with absolutely no track record or reason to give you confidence? To find out about a manager’s tenure, click on the Profile tab on the left side of the Yahoo! Finance Mutual Fund Quote Page (take the Quote Page for Vanguard 500 Index (VFINX), for instance).