(MONEY Magazine) – In 1989, ex-Fidelity Magellan fund manager Peter Lynch published One Up on Wall Street, which preached the mantra that, over time, prices in the stock market dutifully mimic changes in corporate earnings. It took a while, but the sermon has won investors' hearts and wallets. Never before have growth-stock funds--which invest in companies with rapidly rising earnings--been so popular. In the first nine months of 2000, for example, growth-style mutual funds pulled in 25 times as much money as S&P 500 index funds. The passion continues, even as the Nasdaq struggles. Yes, the buyers have lost their taste for Fidelity Aggressive Growth and Marsico Focus--but not for the idea of growth. Funds with better 2000 performance, such as White Oak Growth Stock and Growth Fund of America, continue to vacuum up cash. Makes sense--since growth funds own the companies that are increasing profits faster than other firms, it only stands to reason that such funds will enjoy the highest long-term returns, right?

I'm not so sure. See, the public's current faith in growth stocks isn't exactly justified by the facts. Over the past two decades, academic researchers have learned that growth stocks have generally made less money for investors than the other types of stocks. (The touchstone study was "The Cross-Section of Expected Stock Returns" in 1992 by Eugene Fama and Kenneth French.) This pattern has held true not just in the U.S. but also in Germany, Japan, the U.K., even the emerging markets--you name the place, its growth stocks have disappointed.

One reason is that people overestimate their ability to identify successful growth companies. Sure, it's a snap to find businesses that have latched on to new technologies and are growing rapidly. It's quite another thing to separate the fads from the finishers. Supercomputers or operating software? The investment choice seems obvious now--but not in 1985, when Cray Computer was all the rage. More poetically, an aggressive fund marketer looked to the future in the 1960s and decided to tap into the fast-growing...oceanographic industry. Steadman Oceanographic, it's fair to say, didn't facilitate many early retirements.

Even when the companies are for real, they won't necessarily prove to be great stocks. What if you knew today about a business that would raise its profits by 30% a year for the next seven years. Should you buy its stock?

Maybe, maybe not. Assume that an upstart company has $10 million in earnings and trades at a price/earnings (P/E) ratio of 100. It would then have a market value of $1 billion. Let's also assume that, for the same $1 billion, one could buy a mature, everyday business that has $40 million in earnings and a P/E ratio of 25. Of course, the established company will grow more slowly than the hotshot, advancing its bottom line by, let's say, just 10% a year.

Guess what? Seven years later, the tortoise will still boast higher profits than the hare: $78 million vs. $63 million. The only way for the higher-growth stock to turn in a better performance is if, at the end of seven years, it continues to sport a much higher P/E ratio than the steady grower. That can happen--but there's no guarantee that it will. Indeed, the P/E ratios of high fliers tend to shrink quickly as the firms get larger and their growth rates almost inevitably slow down.

Fund buyers, I've seen your track record. In the mid-1980s, you adored option-writing government bonds. They foundered on 1987's shores and expired shortly thereafter. Then, in the early 1990s, you turned your attention to interest-rate-sensitive bond funds, utilities funds and equity income funds. As if on cue, 1994 brought the steepest interest-rate rise in 70 years. The assets have been leaking out of such funds ever since.

Now don't get me wrong. Much as I enjoy playing Contrarian John, I am not recommending that you forgo mainstream growth stocks and the funds that invest in them. There is, after all, genuine reason to be excited about the technology, communications and health-care businesses. In these rapidly developing industries, the U.S. is the clear and obvious world leader. I respect those facts. All I'm saying is, be wary.

Also, pick up a value fund or two, an international fund, maybe even some bonds. High-yield bond funds are particularly appealing these days--if, that is, you avoid funds that are laden with growth-stock-like telecom issues.

Yes, yes, I know: Risk reduction is for cowards. All right, Braveheart, think of my pitch for diversification as return enhancement instead. It's a fact: All things being equal, a steady portfolio makes more money over time than a volatile one. Take a growth-stock portfolio that has an arithmetic (not annualized) average rate of return of 12% and an annual standard deviation of 25%. (Standard deviation measures how much a fund's performance tends to vary from one period to the next.) By adding value stocks, international stocks and bonds, you might pull the portfolio's average return down to 11%, and standard deviation to 15%. Presto! You're richer. On a compounded basis, the safer portfolio will also be the more profitable of the two. If this strikes you as counterintuitive, consider the following example. Fund A loses 50% in Year One, then gains 100%. Fund B gains 20% in Year One and 30% in Year Two. The arithmetic average return for each fund is 25%, but the compounded results are very different. Fund A goes nowhere, while Fund B gains an aggregate 56%.

It's forgotten now, but Lynch understood this too. In One Up on Wall Street, not only did he advocate "spreading your money among several categories of stocks," but he also wrote that he "never put more than 30% to 40% of my fund's assets into growth stocks." Can you say the same? I suggest that you should.

John Rekenthaler is research director for Morningstar Inc. He has also been publisher and editor of Morningstar Mutual Funds and Fund Investor.