This article is from the How to Start an Investment Program tutorial, author unknown.
Let's discuss how to measure your results and how to set reasonable expectations. The first thing to know is the standard. The two most popular baselines for measuring equity (stock) performance are:
The Dow is the most famous and the most quoted financial average. It is made up of thirty large American companies from a variety of economic sectors. AT&T, Microsoft, Wal-Mart, and Coca-Cola are a few of the names that comprise the index. They were chosen because, to investors on Wall Street, they best represent a cross section of American industry.
The S&P is a broader index, made up of 500 large companies from all sectors of the American economy. It, more so than the Dow, is used to compare the performance of mutual funds. Now that we have our measuring stick, it's time to do some measuring.
It may surprise you, but the fact is that over 70% of all equity funds, managed by professional stock pickers, do WORSE than the S&P average every year. That is, the returns that they provide to investors -- people like you and me -- is less than what could be achieved by putting your money in an unmanaged Index Fund that simply tracks this average!
Why do people, then, keep handing their money over to so called professional money managers and pay them high fees when their results are so poor year after year? One answer is that the mutual funds have large advertising budgets and are very good at marketing their products. In very few ads will you find any comparison with the S&P unless their fund was one of the few that beat the average. Secondly, and most disturbing, the majority of people have a level of financial sophistication that is extremely low. As mentioned before, they just don't know what standard to use to grade the professional money managers.
So how does one go about finding a fund that measures up? A rule that I suggest is to NOT invest any money in a mutual fund that has not outperformed the S&P index (the average) for the last three years. This is the baseline. Why pay for the stock picking expertise of the highly paid fund manager, along with the fund's advertising budget, if you can get better results with less risk by investing in an Index Fund that simply tracks the market? Makes no sense. Stay with me on this point as I discuss Index Funds in more depth in the next chapter.