Check out broad-market index fund

Choosing mutual funds based solely on recent performance can be a recipe for bad performance. Here are some things to think about.

Funds that beat the stock market average one year won’t necessarily beat it the following year. To some degree, a terrific return isn’t the result of the fund manager’s brilliance, but of good luck — at least over the short term. (And many fund managers invest only for the short term.) Many bad funds have occasional outstanding years.

If a fund has a great three-, five- or even 10-year average, that can be due to one amazing year. After all, a five-year average is just an average of five numbers. If one is unusually high, the average will be high. If in each of five years, a fund earns 6 percent, 11 percent, 2 percent, 8 percent and 33 percent, its average annual return will be about 12 percent. That might look respectable, but note that in reality it exceeded 12 percent in only one of five years. That 33 percent return (a statistical “outlier”) skewed the average.

Believe it or not, the majority of stock mutual funds fail to perform as well as the market average (as measured by the S&P 500 index).

So what can you do? Well, consider investing in a broad-market index fund. If you can’t beat the average, you can meet it (and outperform most other mutual funds) by investing in an index fund such as Vanguard’s S&P 500 index fund (ticker: VFINX) or its Total Stock Market index fund (ticker: VTSMX). (Vanguard is at www.vanguard.com or 800-662-7447.) To do even better, seek out those select funds that do fare better than average consistently. Ideally, they’ll have no loads, expense ratios below 1 percent, and thoughtful managers who invest their own money in the funds.

Learn more about mutual funds at www.funds.fool.com and research them at www.morningstar.com. Also, check out the top-notch, low-fee funds we’ve recommended in our Motley Fool Green Light newsletter. Try the service for free at www.fool.com/shop/newsletters and read all about them.

Ask the Fool

Q: What are buy-side and sell-side analysts? — R.H., Kailua Kona, Hawaii

A: You’ll find buy-side analysts working in-house for institutions such as mutual funds and pension funds. They study possible investments and recommend which securities the institutions should buy or sell. Sell-side analysts traditionally work for brokerages, trying to sell their ideas to institutions. If an institution likes a brokerage’s research, it might do business with that brokerage.

Many brokerages now offer us investors access to sell-side analysts’ research reports on various companies.

My dumbest investment

I fell for a stupid penny stock company that made bomb-detection devices. The company released one fluff-filled press release after another, which always sounded like it was ready to turn a corner. I also bought into some of the pump-and-dumpers hyping the stock online. I learned some expensive lessons. Don’t take advice from morons, and if it looks too good to be true, then it probably is. Doing your due diligence is important. The company is a complete disaster and is on its way to bankruptcy. — Chris S., Grove City, Ohio

The Fool Responds: Penny stocks are dangerous because they often have no track record of growing sales and profits. They can also often be easily manipulated by folks who buy them, hype them online (“pumping”) so their price rises as others pile on, and then sell the stock (“dumping”) quickly, causing it to crash. It’s usually smart to avoid stocks trading for less than $5 per share. Instead, look for consistent growers with low debt, strong cash flow, talented management and competitive advantages.