Money Magazine's funds for 2007: Why you should ignore lists like this

Each year, Money, along with the rest of the financial press, trots out its favorite mutual funds for the new year. I have a suggestion for how savvy investors can use such guides to select mutual funds: crumple them up, throw them in the trash. Then read The Boglehead's Guide to Investing, a great treatise on investing the John Bogle way. After that, log on to Vanguard.com and buy some indexed mutual funds.

But I digress. Here's why you should ignore Money's list of "the best mutual funds you can own." According to their own statistics, 67% of the "Money 70" funds performed in the top half of their category in 2006. That's a fairly impressive short-term track record, but certainly not amazing. It's even less amazing when you consider that Money screened for funds with low expense ratios, and the average fund that they selected had an expense ratio just over half that of the average mutual fund.

Here's the problem: according to all the relevant research (most notably in John Bogle's book), there is an extremely high correlation between a fund's expense ratio and its performance. It's the single most important factor in selecting a mutual fund. While I haven't run the data, I suspect that simply selecting all mutual funds with low expense ratios would provide a success rate better than the 67% that Money reported for their list. I just don't see anything particularly special about Money's list, and certainly nothing worth spending a few dollars on a magazine for.

Bottom line: the most important factor in selecting mutual funds is the expense ratio. To achieve strong diversification at an extremely low cost, consider buying Vanguard's total market index funds, as well as some of their international index funds for additional diversification.