Okay, play before work: when theOtherGuy and I were designing the new site last Friday, it was a total nightmare. I wanted to get the Blog Post of the Week! up before midnight (so that Andrea from SoOverDebt.com could get both of our reader’s attention). Running out of time, I just grabbed a pic of my blog-writing friend Cooper. My cat.

Yesterday, my friend Doug—who has a lifetime of tech work behind him–was commenting on the new site layout:

(finally) Doug: …and one more thing, get rid of the cat picture.

me: Ha!

Doug: I know you think I’m joking. I’m not. It’s a deal breaker. Take down the cat.

me: (suddenly miffed for no reason whatsoever): Ha!

So now, completely out of spite, Cooper’s pic is going to stay on the site for the next seven days. Our Alexa site rank will probably plummet. No advertisers will touch us (nothing new there). But because Doug said “deal breaker”, Cooper gets his seven days of near-fame.

Now, on with the show……

SmartMoney.com yesterday published a list of the top 100 funds of the past 5 years. We’re inundated with these types of lists in January. I had a rare opportunity to read USA Today on my way home from Disney last week, and long-time finance writer John Waggoner penned a piece titled Fund Investors Ran in Place in ‘11. The story discussed what we already know: 2011 was a roller coaster year, with the average stock fund, according to Lipper, losing 2.9 percent. Investors are scrambling to find better results.

That wasn’t shocking.

What I found annoying was the story’s partner: “More on Funds, Quarterly, Yearly Results Tables….”. It was pretty much the same story I saw yesterday at SmartMoney. The obvious (unstated) connection I believe readers will make is that they’ll find better fund by reviewing the best ones from last quarter or last year.

USA Today and SmartMoney wouldn’t run stories featuring the top ten mutual funds (or 100….or whatever) if people didn’t search for this information. I don’t fault them at all. It sells. Turning to the USA Today piece, here’s a listing of the 4th quarter’s best and worst, as well as the 12 months’ best and worst funds. One page over I find the list of the top funds over 5 and 10 years.

Yuck.

Stop reading about the Top Ten Mutual Funds.

In his seminal investing book The Truth About Money 4th Edition’ target=_blank>The Truth About Money, financial advisor Ric Edelman discusses this thirst people have to throw money at last year’s winners. We want to own winning funds. Many of us have heard grandpa tell stories about the legendary returns of Fidelity Magellan back in the day, or of that high-flying Janus Twenty fund in the months leading up to the tech wreck. We want those days back. We’d love nothing more than to be invested with some manager who always makes us money. But as Edelman describes, history works against you if you’re trying to find great results this year by reviewing last year’s winners.

Looking at the top ten mutual funds rarely produces winning result.

WHY SHOULDN’T I INVEST IN LAST YEAR’S WINNERS?

• When everyone clamors to enter a fund, investing millions of new dollars, the fund is doomed to failure. According to this study: Star Power: The Effect of Morningstar Ratings on Mutual Fund Flow, funds with high returns one year and Morningstar rating upgrades nearly immediately experience an unnaturally high gain in assets. These assets must be invested by the manager, who finds it more difficult to spread the investment among quality names. You’ll rarely find a manager can keep up with these huge asset spikes.
• Often, the top ten mutual funds and ETFs are in specific categories which spiked during that calendar year. In 2010, commodity names like silver and cotton performed handsomely. In other years, real estate, large company stocks, or internet stocks have been big winners. If you invested in silver or cotton in January, 2011 based on 2010 results, you stepped in it. To mis-quote Sarah Palin, “how’s that workin’ for ya’ now?”
• You may pay handsomely for a top fund. Funds with high expenses which spike may be especially dangerous. One top fund of 2010, Morgan Stanley Focus Growth B (AMOBX) carries an expense ratio of 1.77 percent. This fund competes against the S&P 500. If you’d purchased iShares S&P 500 index exchange traded fund, your expense would have been 0.09 percent, plus any trading costs. Big difference.

Here are some top funds, ETFs and ETNs listed in “best of” 2010 publications and their 2011 results:

In November of 2010, TheStreet.com listed the top performing funds competing with the S&P 500 here.

In January 2011, USA Today published a chart of the top performing funds of the year, which included ETFs and ETNs.

HOW SHOULD I PICK FUNDS?

• As writer Steven Covey preaches, begin with your end in mind by laying out achievable goals.
• Determine the return you’ll need to reach your goal.
• Pick a mix of assets which has historically achieved that goal with as little risk as possible, using asset allocation software.
• Choose funds using this primer we unveiled last year (for free!)
• Protect your downside with stop losses (if possible) or a strict loss-management strategy. We’ll address this area in the next few weeks.

(Photo credit: Crosa: Wikimedia Commons)