This is a repost of an article that appeared on Story Stocks in 2007.

Perhaps you have heard that 75% of actively managed mutual funds will fail to keep pace with the general market over any significant period of time. Well, you heard right. With history as my guide, I can confidently proclaim that the vast majority of mutual funds will underperform the market over the next five years.

There are a number of reasons for this. Let’s look at a few:

1. Mutual funds are often overdiversified.

A diversified mutual fund must hold a minimum of 20 stocks, with many funds owning over 100 or even a thousand individual securities. As you might imagine it’s difficult to reap the rewards of a big winner if it represents 1% of your total assets. Furthermore, who has 100 or 1000 good investment ideas at any time. Of course that’s not the only reason funds fail to outperform the market.

2. Mutual fund managers must invest even when they believe the market is overvalued.

When a mutual fund has a successful period a boatload of new money often flows into it. The fund manager is forced to put this money to work buying more shares at a considerably higher cost or initiating new positions. A fund manager often can not or will not hold a significant cash position in wait of a better opportunity.

3. Even no-load funds bear expenses for shareholders.

All mutual funds have an annual expense ratio (the average for a stock fund is 1.4%). In effect the fund must outperform its respective benchmark by the amount of its expense ratio just to meet the return of the market. For instance, a general equity fund may charge you 1.25% for the honor of managing your money. But if it does not beat the S&P by about 1.15% (the SPY carries a .08 expense ratio), you’re losing money.

4. Mutual fund managers must report their holdings quarterly.

It’s often been said, and I believe it’s true, that no money manager ever lost his job investing in IBM. It’s a simple fact of life that no one wants to look foolish. So creativity is severely lacking among this group of professionals.

Now, all of this is good news. If you’re invested in actively managed domestic mutual funds, get out now. And where should one stash one’s cash? In an index fund? Well, I don’t believe that’s the most appealing option either as $10,000 invested in the S&P 500 10 years ago would be worth just $14,800 with all dividends reinvested. That clocks in at just over a 4% return annually. Hardly anything worth writing home about.

If you have the time and the inclination, I believe you’d do best in individual stocks. You do not have to overdiversify. Your expenses are limited to trading costs ($7 a trade). You’re never forced to buy. And you don’t have to publish your results for the world’s inspection.

So that begs the question, “What do I invest in?” Now your starting to talk my language.

Scour the web. If you’re reading this blog, you’ve taken an important first step. But don’t stop there. Check out the resources listed in the sidebars. (I think Peter Lynch’s One Up on Wall Street is a great place to start.) Read the Motley Fool. Create a model portfolio on Yahoo! Finance. And save, save, save.

After all, you have the advantages. The only thing the professionals have in their corner is an element of fear. They want you to believe that you can’t manage your own money, that you’ll somehow lose it all. The reality of the situation is that it’s likely you’ll do better than they will.