There is a lot of confusion about the best way to invest given the current environment, and an equal amount of confusing messages coming from the financial media. One of the things I enjoy doing is clarifying some of the mystery that surrounds investing for many people.

One area of confusion is why mutual funds did so poorly last year. Conventional wisdom says to diversify across many kinds of stocks, and one way to do this is to invest in mutual funds. And yet, the vast majority of mutual funds did little better than the overall market. One reason for this is to consider the dilemma faced by mutual fund managers. If a mutual fund manager is losing money while everyone else is losing money, he or she still gets to keep their job. On the other hand, if a manager loses money while everyone else is making money, they quickly find themselves in another line of work. This creates something of a herd mentality and keeps most funds fairly close to each other. The major difference over the long-term tends to be expenses.

There are always a few managers who try to differentiate themselves, and statistically some of them will be successful. Of course, the successful ones get a lot of press and their own radio shows, but the vast majority who try to be different end up simply being out of a job.

Another problem is that most popular mutual funds are organized by geographic location (U.S. vs foreign) and company size (large company/small company). In the past, this made sense because U.S. and foreign markets were somewhat independent (non-correlated), but this is clearly no longer the case. Also, small companies used to be purely local businesses, and only large companies had global reach and were subject to currency exchange rates and other global factors. Communication technology and the Internet has largely eliminated these differences. The result, is that all of the traditional mutual fund classes behave pretty much the same when looked at over the last 5 or 10 years. This is likely to continue in the future, if not get worse.

One way to avoid this problem is to use individual stocks from different sectors, for example Technology and Energy and Health Care, which will likely always behave independently. Sector diversification has been around even longer than mutual funds, and bookstores are full of theories about how to do it, but it requires stock-picking skills (GM seemed like a good stock not too long ago). The stock-picking requirement can be avoided by using Exchange Traded Funds (ETFs), which give exposure to an entire sector at a time. ETFs are extremely inexpensive, and trade exactly like stocks. The performance difference over the last 10 years of a portfolio diversified by sectors versus diversified by company size and geographic location (which is not really diversified) is dramatic.

The key point is that sometimes we need to re-examine the traditional way of doing things, and this definitely applies to investing. I don't believe the problem with traditional mutual fund investing has been caused by the latest bear market, but rather the bear market has exposed some problems that have been growing for quite a while.