(MONEY Magazine) – IT NEVER CEASES TO AMAZE ME HOW OTHERWISE SKEPtical and intelligent people invest in mutual funds without ever questioning the myriad factlets, sayings and pseudostatistics that, over time, have achieved almost mythical status. Well, after a truly boffo year in funds, I'm here to remind you that while the conventional wisdom isn't always flat wrong, it's seldom as wise as it might seem. Put another way, there's a world of difference between good advice and advice that sounds good.

So what are the fund myths that can lead you astray? Over the years I've collected dozens of them. Like the Greek legends of old, they all sound compelling. And that's the problem. They seem so simple and clear that you want to believe them unconditionally. But if you do, you may find yourself, like Icarus, flying toward financial meltdown. Thus with the warm glow of 1995's happy returns still fresh in memory, here in rough order of their fallacy are my nominees for the dozen deadliest mutual fund myths, each with a lesson to make you a smarter, richer investor.

FUNDS ON A HOT STREAK WILL GIVE YOU SCORCHING LONG-TERM RESULTS

YOU'D PROBABLY DISMISS AS NAIVE SOMEONE WHO PREdicted that the Atlanta Braves will win the next World Series because they won last year's. So why would you think a mutual fund will finish on top in '96 simply because it had a hot '95? Strangely enough, lots of people do.

These days not many folks remember Oppenheimer Ninety-Ten Fund. It was the top-performing fund of 1987, with a 94% return. But it doesn't even exist anymore; in 1991, Ninety-Ten was absorbed into Oppenheimer Asset Allocation Fund. Similarly, Oppenheimer Global Bio-Tech Fund skyrocketed 121% in 1991, then lost 23% the next year and morphed into Oppenheimer Global Emerging Growth Fund in 1994.

I'm not picking on Oppenheimer, which runs a solid shop. History is full of flash-in-the-pan funds, and the lesson is clear: Short-term past performance is not a reliable guide to the long-term future. Study after study proves it. So you could have knocked me over with a feather when both Esquire, the hip men's magazine, and the Journal of Financial Planning, the decidedly uncool official publication of the Institute of Certified Financial Planners, recently recommended buying the funds with the hottest returns over the past 30 days. Hey, why stop there? Fidelity prices its industry-specific Select funds once an hour; why not buy whichever one went up the most between your coffee break and lunchtime, then sell it at 4 p.m. and start all over again the next day?

If you're not convinced yet of the fallacy of buying last year's sizzlers, ask yourself what you gain by chasing performance. The answer: a whopping tax bill--unless you fling your hot funds around in a retirement account, in which case you'll just give yourself ulcers. Ask your accountant what your combined federal, state and local tax bracket is. Say it's 38%. That means your churning basket of hot funds has to outperform an S&P 500 index fund by more than 38% a year just to stay even with it after tax. If you think you can pick funds that brilliantly, go to the nearest body of water and try walking across it. If, like me, you sink, then forget about picking hot funds. (If you don't, you can forget about funds entirely.) My rule: If you're not committed to owning a fund for at least five years (preferably a decade), don't buy it at all.

FOCUS ON PERFORMANCE AND DON'T SWEAT THE SMALL STUFF--LIKE ANNUAL EXPENSES

NEWSLETTER WRITERS, BROKERS AND FUND EXECUTIVES like to say that investors pay too much attention to annual expenses and too little to performance.

Poppycock.

In fact, investors pay far too much heed to performance and not nearly enough to expenses. Costs matter. Period. Here's why:

A fund's annual operating expense (or "expense ratio," in fundspeak) is reported as a percentage of total net assets. That keeps it looking small--usually under 2%. On a $1,000 investment, for example, 2% in expenses eats up just $20 a year. But now look at it my way: If your fund earns 20%, that 2% expense ratio eats up a tenth of your return. In other words, the fund company really charged you 10% in expenses, not 2%. Decades ago, funds routinely reported their expenses as a percentage of investment income, so you could see how big the bite really was. These days, you have to do the math yourself.

If, as I expect, the long-term return on stocks after all taxes and inflation works out to less than 4%, even a fund that reports just 1% in expenses will devour at least a quarter of your take-home return. And over time, the average low-expense fund is certain to outperform the average high-expense fund. That's not just my opinion; it's a mathematical fact.

Here are my rules: Don't buy an investment-grade bond fund with expenses above 1% of net assets (for junk bond funds, 1.25% is the limit). Don't buy a U.S. stock fund with expenses higher than 1.5% (go a little higher if you want to own a small-cap fund). Don't buy an international fund with expenses above 2%. Hundreds of terrific funds easily pass those tests. If you own any that don't, write the fund companies and complain about their high costs.

THE MORE FUNDS YOU OWN, THE MERRIER YOUR PORTFOLIO WILL BECOME

MANY FINANCIAL PLANNERS AND BROKERS RECommend that you hold well over a dozen funds at once to spread your risks. Hogwash. You simply don't need duplicate funds with the same investment objectives, such as long-term growth. True, some growth managers buy classic earnings-driven shares while others go for out-of-favor value plays. But many of their holdings will be remarkably similar. Thus more funds may not be better; more may just be, well, more.

My view is that 10 funds, max, should work for most investors. Here's my recipe: In both your taxable and tax-deferred accounts like IRAs and 401(k)s, start with a large-stock fund, such as an S&P 500 index fund. Then add a diversified international stock fund in both your taxable and tax-deferred caches. If your federal tax bracket is 28% or higher, put a municipal bond fund in your taxable account. Put a junk bond fund or an intermediate-term (not a long-term) Treasury fund in your retirement account, where its yield won't bloat your tax bill. One money-market fund is plenty; or, if you don't write checks on the account (which will create tax complications), a higher-paying short-term bond fund is a better choice for your cash. Add a small-cap fund if you insist--but, as I'm about to tell you, don't expect it to gild your returns in the long run. If you don't own any hard assets like a house, you might also want an inflation-hedging fund, which I'll discuss in a minute as well.

IF YOU WANT TO SCORE THE REALLY BIG BUCKS, LOAD UP ON SMALL-CAP FUNDS

ACCORDING TO OFT-CITED NUMBERS FROM IBBOTSON Associates of Chicago, small stocks have beaten big stocks by two percentage points a year since 1926 (12.5% to 10.5%). Why? Small stocks, says the conventional wisdom, are "inefficient"--so little studied by Wall Street's researchers and the investing public that bargains abound.

I ran that idea past small-cap investing pioneer Charles Royce, who runs $1.7 billion in little stocks at the Royce Funds in New York City. Like me, he thinks it's baloney. Says Royce: "The mythology says small-caps are so inherently inefficient that they're like automatic gold in the streets. Ten years ago, that was true. But I couldn't look anyone in the face today and say small-caps are inefficient--not with so many funds out there, not when any investor can instantly get the same information on any small company." My own view is that nowadays only "micro-cap" stocks, the shrimpiest companies with market values of less than $200 million or so, remain inefficiently priced.

Another problem with the small-is-beautiful thesis is that for most of the past 70 years, the big returns from those small stocks were produced by the littlest 20% of companies (measured by total market value) on the New York Stock Exchange. Fair enough. But those shares are hardly the dinky NASDAQ stocks favored by today's small-cap fund managers.

Not to put too sharp a point on it, but people who say you can get a huge boost by putting a third or more of your portfolio in small-cap funds are full of hot air. Consider that the grandaddy of all small-cappers, $2.8 billion T. Rowe Price New Horizons, has outperformed big stock funds by only about a percentage point per year on average since its inception in 1960. That's about the biggest edge you can expect, and much of it was earned in the 1970s. My advice: If you really want to capture any possible small-cap advantage, put a sliver (say 10%) of your assets in a microcap fund specializing in true midget stocks--and be prepared to ride with the fund for 10 years or more. It may take that long for the stocks' values to be realized. Some promising choices: Jurika & Voyles Mini-Cap (800-584-6878; 1995 return: 52.2%), Royce Micro-Cap (800-221-4268; three-year annualized average return: 15.5%) and Wasatch Micro-Cap (800-345-7460; return since June 1995 inception: 37.5%).

AGGRESSIVE GROWTH FUNDS WILL PUSH YOUR PORTFOLIO SKY-HIGH

THIS MYTH IS A FIRST COUSIN TO THE ONE COVERED in the preceding section. So imagine my amusement when Smart Money magazine exclaimed in December 1994: "A $1,000 annual investment getting a 20% return in an aggressive growth fund will leave you with $224,026 in 20 years." The math's okay, but the idea is wacko. To begin with, no aggressive growth fund in existence has averaged 20% annually for the past 20 years. Unless you expect a titanic bull market over the next two decades--and I don't--this isn't even a myth. It's sheer fantasy.

Since January 1976, according to the fund analysts at Morningstar in Chicago, aggressive growth funds have returned 17% annually, beating the stock market by 2 1/2 percentage points per year. But I don't think 1976 is a good place to start counting. That's because stocks were just nosing up from the worst dive since 1929, and the riskiest funds may have got the biggest lift in the bull market that followed.

Go back deeper in time, and the case for aggressive growth gets muddier. Take a look at Lipper Analytical Services' data on capital appreciation and small-company growth funds--two aggressive investing styles--dating back 25 years. Small-company growth funds did perform a tad better than plain old growth funds, rising by 12.7% a year, vs. 11.9%. But capital appreciation funds fell behind by a hair, gaining 11% annually. Neither number proves that aggressive growth pays off--and certainly not big--in the long run.

My counsel: Put the bulk of your long-term money in a conventional growth fund, not in one dubbed aggressive or small-cap. For a superb low-cost core holding, choose Vanguard Index 500 (800-662-7447; 10-year annualized average return: 14.9%); over the long haul, this fund has beaten more than two-thirds of all rivals. If you're still panting for a more aggressive fund, consider one of the microcaps I mentioned earlier or one of the stars profiled in "Nine Funds That Deserve To Be in the Spotlight" on page 72.

INVESTING IN JUNK BOND FUNDS IS A SUCKER'S GAME

THE MEMORY OF 1989 AND 1990, WHEN MANY JUNK bond funds lost a quarter of their value, is painfully fresh. And rightly so. But get this: From 1985 to 1994, junk bonds delivered 99% of the return of long-term Treasury bonds--about a 12.5% annual average--at barely one-third the risk. That's because bonds issued by young or financially feeble firms pay a higher rate of interest than do Treasuries; thus they return more money to you sooner, thereby shielding you better from the damage of rising interest rates.

In judicious measure--say up to 20% of your portfolio--junk bonds are a defensible long-term investment, far less risky than most people believe. However, they are usually not suitable for taxable accounts, since their high current income will hike your tax bill. Hold them instead in tax-deferred stashes like 401(k)s and IRAs. Some worthy funds to consider, all of which have outperformed the category average over the past decade: Fidelity Capital & Income (800-544-8888; 10-year annualized average return: 11.5%), Northeast Investors (800-225-6704; 10-year return: 10.7%) and Vanguard High-Yield Corporate (800-662-7447; 10-year return: 10.5%).

KEEP 5% OR 10% OF YOUR PORTFOLIO IN GOLD FUNDS, WHICH ARE A GREAT INFLATION HEDGE

GOLD ITSELF HAS PROVED A WORTHY INFLATION BEATER over time. Its price gains, according to the data mavens at Ibbotson Associates, have outpaced rises in the consumer price index, especially in times of high inflation. But understand this about investing in glitter: Gold funds don't always have the mettle of the metal itself.

Over the past 10 years, for example, gold prices averaged a piddly 1.7% annual increase--but two leading gold funds, United Services Gold Shares and Lexington Strategic Investments, lost 16% and 5% of their value, respectively. That's because gold funds don't usually buy bullion. Rather, they buy the stocks of companies that run gold mines or related businesses, which may not always be as good as gold.

In short, I say skip gold funds. If you want to hedge against inflation, buy a house in a stable neighborhood of a growing community. Or consider T. Rowe Price New Era, which holds a basket of inflation-busting assets like timber, mining, and oil and gas stocks (800-638-5660; 10-year annualized average return: 11.2%).

YOU CAN TURN A LOAD FUND INTO A NO-LOAD THESE DAYS

MANY BROKERS ARE PUSHING SO-CALLED CLASS B OR class C shares of load funds as low-cost alternatives to old-fashioned front-end loads. I've personally been told by several brokers that these weird alphabet funds are "no-loads." Fact is, a load is a load, whether you pay your broker's commission in one lump up front or in, say, 1% increments for several years (as you customarily do with the B or C shares). Don't get fooled. Not only do these B or C shares still charge loads, but they can end up costing more than the original front-end-load version of the fund if you hold them for five years or longer. (And if your broker doesn't make you stay put in a fund for at least five years, what good is he or she?) A 5% front-end load, spread over a five-year holding period, is 1% annually; many alphabet funds keep charging that much for six years or even more.

Under a new National Association of Securities Dealers rule, brokers must discuss which form of mutual fund sales charge is most suitable for a customer like you. If your broker fails to explain the different ways you can pay him, get a new broker. The best bet: Pay your broker the old-fashioned way, via an up-front load. One load-fund family that has said no to alphabet soup is the 28-fund American Funds group of Los Angeles (800-421-0180).

YOU SHOULD OWN A DOUBLE-TAX-FREE FUND, WHICHEVER STATE YOU LIVE IN

RESIDENTS OF SEVERAL STATES WITH NO INCOME TAX, like Florida, Texas and Washington, can buy municipal bond funds that offer tax-free bonds from within the state. So what? Every other state's muni bonds are also tax-free if you live in those three states. Why buy an in-state fund with a sales load or a high expense ratio when you can get a national muni fund--with identical tax benefits--from low-cost providers like Benham, Fidelity, Safeco, Scudder, USAA or Vanguard?

Even in states that do have an income tax, you'll often be better off with a low-expense national muni fund than with a double-tax-free fund. That's because the extra expenses on the in-state fund tend to gobble up your tax savings. What's more, how do you know you won't be moving to a new state? Your old Kentucky muni fund won't do much for you if you relocate to Arizona. Unless you live in a very-high-tax state like California, Massachusetts or New York, skip the double-tax-free fund and go for a national muni fund instead.

DOLLAR-COST AVERAGING INCREASES YOUR RETURNS

CONVENTIONAL WISDOM HOLDS THAT DOLLAR-cost averaging--investing a fixed amount of money in a fund each month, each quarter or each year--will boost your portfolio's performance. Unfortunately, it's not true. Dollar-cost averaging almost always lowers risk, but it does not raise returns. Assuming the stock market continues its long uphill trend, you will always get a higher return on your money if you put more of it to work earlier, rather than reeling it out slowly into the market.

Listen to me very closely. I'm not saying dollar-cost averaging is a bad thing. It does reduce risk, since you are less likely to heave a hunk of money into the market right before a crash. Thus you're less likely to panic and pull it out at just the wrong time. What's more, there's no better way to force yourself to invest automatically, especially if you have a hard time pinching pennies to put in the market. What I am saying is that neither dollar-cost averaging, nor anything else, is a magic wand that can pull big returns out of hats. Nor can it totally extinguish risk. It merely dampens it.

INTERNATIONAL FUNDS ARE A GREAT WAY TO MAKE A QUICK KILLING

BACK IN 1993, A SLUGGISH YEAR FOR U.S. stocks, investors heaved a record $40 billion at mutual funds that invest abroad. That year the average international fund shot up 38.8%, and U.S. investors thought they had found paradise. Oops. In 1994, the average international fund lost 3%. And last year, as U.S. funds showered 30% gains on investors, international funds rose a measly 5%.

Too many of 1993's buyers did not understand something vital: The performance of foreign stocks is partly driven by the value of the U.S. dollar. Think of it this way: When you put $1,000 into an international fund, you are selling a thousand greenbacks and buying a basket of pounds sterling, French francs, German marks, Japanese yen, Dutch guilders or Indian rupees. That's because the fund has to exchange your dollars into francs and yen to buy stocks denominated in those currencies.

If these other currencies later rise in value against the buck, your fund will get a boost because its foreign holdings can be converted back into more U.S. dollars. Since 1985, the U.S. dollar has slumped against other currencies. Over the past decade, Morgan Stanley Capital International's index of European and Asian stocks returned an annualized average of 12%--and just under half of that handsome return came from the fall of the U.S. dollar.

So bear this in mind: If the dollar reverses its long decline, international stocks may not perform as well as they did in the past decade. But don't let that discourage you from buying international funds. Instead, remind yourself to be realistic. International funds are not a get-rich-quick scheme. They should be a permanent part of every smart investor's portfolio. Putting up to a third of your portfolio in international funds--and keeping it there through thick and thin--will improve your returns and lower your overall risk.

VIRTUALLY ALL INVESTORS SHOULD OWN AN EMERGING MARKET FUND

IT'S HARD NOT TO GET CARRIED AWAY IMAGINING THE huge returns on your emerging market fund once those zillions of people in China can afford to smoke more, drink more, drive more sports cars and buy more life insurance.

But consider this: The greatest emerging market ever was probably the U.S. in the 19th century, when the railroad, steel, oil, mining, electrical and telephone industries all exploded into prosperity. Yet, according to Jeremy Siegel, a professor at the Wharton School of Business in Philadelphia, U.S. stocks averaged a 7.1% annualized return from 1802 to 1870, a smidgen below their 7.2% average return from 1871 to 1925--and miles below their 10.5% return since 1926. So it's entirely possible that today's emerging markets--like the U.S. market of the 19th century--will actually underperform their developed siblings. On the other hand, since 1989, they've been on a roll, returning 18.2% annually, vs. 15.4% for the S&P 500.

Who really knows what will happen in the long run? What I can tell you is this: Emerging markets are wildly risky. By my math, since 1989 they have bucked up and down nearly twice as violently as the U.S. stock market.

My advice: Don't even consider an emerging market fund unless you're prepared to hang on for at least a decade. Better still, I'd steer clear of pure emerging market funds and stick with diversified international funds instead; they are far less risky. Acorn International (800-922-6769; three-year average annualized return: 15%), T. Rowe Price International Stock (800-638-5660; three-year return: 14.7%), Scudder International (800-225-2470; three-year return: 13.9%) and Warburg Pincus International Equity (800-257-5614; three-year return: 18.2%) have all beaten the average international fund's returns and hold less than a third of their assets in emerging markets.

I'll leave you with a few general thoughts: If a fund category is extremely trendy--like utilities in 1993, health care in 1991 or option income in the mid-1980s--it's about to become a very bad idea. If you're tempted to buy it, wait until it goes out of fashion; then look again. Always remember that you are investing in mutual funds not for today, not for tomorrow, but for a generation. Finally, a fund (or any investment) that promises huge returns at low risk is the modern equivalent of the mythical Greek centaur--half man, half horse and all fantasy.