The financial media has done a steady and regular job of denouncing actively managed funds the last three years.  No wonder - according to 98% of all mutual funds have failed to beat the S&P 500 over the last three years ended 12/31/98.  Does that mean that any fund that has failed to beat the S&P 500 is a bad fund?  Heavens no and here's why. 

There are many different types of mutual funds.  Some funds invest in large capitalization stocks while others invest in small cap stocks.  Some funds invest in "growth" stocks while others invest in "value" stocks.  And of course, some funds invest in hybrids of all of the above.  The reality is that funds that invest in anything other than large capitalization growth stocks have substantially underperformed the S&P 500 the last 3 years.  All the action has been concentrate on large cap growth.  These other funds are zigging while the S&P 500 is zagging.

Of course it is possible you could have made more money in the last 3 years if you had put 100% of your money into an index fund.  But any investor with a diversified portfolio would have naturally underperformed the S&P 500.  Small caps have been in a slump.  Value stocks have delivered much less profit than growth stocks.  International funds have badly underperformed the US stock market.  The reason to diversify is that no one can know in advance what the future will hold.  A diversification strategy strives to help you insure that you will have a portion of your portfolio invested in an area that is doing well.  The purpose of diversification is not to maximize your investment results.  The purpose of diversification is to manage risk and lower volatility.

A lot of investors have been tempted to jump on the index fund bandwagon lately.  After all, that is where all the action has been.  The problem with that strategy is that it is investing through a rear view mirror.  Yes, index funds and funds that invest in large cap growth stocks have done the best recently.  It would be a mistake to believe that this trend will last forever.  There will be times in the future when small caps or value funds or international funds will be producing the best results.  A well-structured diversified portfolio should help you participate in that change in leadership.  The bottom line is that asset allocation and diversification is a long-term strategy designed to smooth out the peaks and valleys of investing.  You may not like seeing your peak shaved down a few points, but you'll love it when the stock market isn't as hospitable.  Small caps stocks tend to experience greater volatility than large cap stocks.  International investments involve special risks, including economics and political uncertainty and currency fluctuation.  The S&P 500 is an unmanaged index; investors can not invest directly in indexes.  Past performance does not guarantee future results.  Mutual fund investments involve market risk, including fluctuating returns and possible loss of principle.