Do not Say You Were not Warned

With the so-called lost decade close in our rear-view mirror, many investors think putting their money in index funds or ETFs that track the market just won’t be good enough to secure a nice retirement. And I can’t totally blame you if you feel that way; it’s certainly been a rough decade. But if you’re thinking about placing your hard-earned cash in a mutual fund with the promise of crushing the market, let me explain why that’s a bad idea and how you avoid making an enormous and costly mistake.

Not exactly what you signed up for

You see, managed mutual funds suffer from three specific ailments.

First, they can have insanely high fees. There’s always an expense ratio, which charges you a percentage of your investment. But funds will often tack on a “management fee,” a “12b-1” fee (which is basically a marketing fee), and sometimes even a purchase fee the fund charges you every time it purchases a stock! When you add all these fees up, it makes it almost impossible for you to generate enough returns to offset the extreme costs of doing business.

Second, actively managed mutual funds typically have very high turnover. This means that they are constantly buying and selling stocks; every time they do so, they incur a commission fee that is ultimately passed on to you again, as a fee. Instead of buying and holding for the long term, managers often feel the pressure to buy turnaround stocks like Sirius XM Radio and then dump them once they’ve secured a modest profit.

Third, mutual funds don’t always offer you the diversification you think you might be getting. For instance, say you want diversified energy exposure, so you invest in Energy Select Sector SPDR (XLE) but then you learn that nearly 30 percent of its holdings are concentrated in just two stocks: ExxonMobil and Chevron.

Not only is this not the type of broad diversification you signed up for, but you’d probably be better off owning these two companies separately. Both companies pay solid dividends above 2 percent and are trading for earnings multiples below 15 that’s a pretty sweet deal.

Combined, these three reasons are probably why, historically, 80 percent of mutual funds underperform the stock market’s return in a typical year. And now it seems as though we’re continuing to flood the market with more and more capital not exactly a great sign for investors.

A much better alternative
Investors who actually want to beat the market need to be buying individual stocks. Discount brokerage firms like Charles Schwab have lowered their trading fees so much that investing on your own is now a truly inexpensive option. Investing in stocks on your own means you don’t have to put up with all sorts of ambiguous fees, which lowers your costs and ultimately will lead to great returns.

And because you’re in charge, you aren’t captive to high turnover rates, and you can actually be a buy and hold investor. Lastly, it also means you can take charge of diversification, picking and choosing the stocks that you think will give you the best return for the least risk.

But picking stocks can be a daunting task that is, unless you know the right places to look.

Where to look
Start by looking for stocks with the following characteristics:

* Low price-to-earnings ratios.
* Historical earnings growth.
* Potential for future earnings growth.
* Management you can trust.
This will ensure you’re buying a stock at a reasonable price, and that there’s a good chance that company’s value will increase over the long haul.

To get you started on this process, I ran a screen for exactly the attributes listed above: cheap valuation, past and future earnings growth, and a high return on equity to illustrate that management knows how to allocate capital. Here are four stocks that I feel really fit the bill:

These stocks all have great characteristics that deserve your attention and some more due diligence to see if they fit your investing style.

One stock that our Million Dollar Portfolio analysts really like right now is Infinera, a leading provider of optical networks. With a rock-solid balance sheet ($272 million in cash and no debt), this company has the financial wherewithal to really expedite its growth at a stellar pace. This company has the ability to make optical networks faster, cheaper, and more efficient. Not to mention the company boasts that it can roll out a 1,300-mile network in only five days. This makes the company’s solution not only affordable, but extraordinarily quick. Yet in 2010, the stock has dropped by about 5%, which caught the eye (and the recommendation!) of our Motley Fool analysts.

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