This is a post from staff writer Robert Brokamp of The Motley Fool. Robert is a Certified Financial Planner and the adviser for The Motley Fool’s Rule Your Retirement service. He contributes one new article to Get Rich Slowly every two weeks.

On this Halloween, I have a frightening tale of decaying wealth, failed attempts at resurrection, a dying reputation, and a Lynching. Of course, I’m talking about the Fidelity Magellan Fund, once the largest mutual fund in the world. And you should listen to me, because I once dressed as Suze Orman for Halloween.

Suze "Brokamp" Orman

Brokamp's Halloween costume

You may have heard of the Magellan Fund, or its onetime star manager, Peter Lynch. He ran the fund from 1977 to 1990, and produced an average annual return of 29 percent, outperforming the S&P 500 by almost 14 percent per year. To illustrate how powerful such performance can be, I fired up my Morningstar Principia Hypotheticals software and calculated the return statistics for Magellan from Jan. 1, 1977, to Sept. 30, 2012, and compared those numbers with an identical investment in the Vanguard 500 Index fund, which aims to track the performance of the S&P 500 (a common measure of the overall U.S. stock market).

Fund Avg. Annual Return Total Cumulative Return $10,000 Turned Into…
Magellan 15.0% 14,813.9% $1,491,390
Vanguard 500 10.5% 3,497.1% $359,709

First, an observation about the mathematics of investing. You might think that an investment in the Magellan fund would be worth approximately 50 percent more than an investment in the Vanguard 500, since Magellan’s average annual return was approximately 50 percent more than the Vanguard 500’s. But actually, the resulting amount is 414 percent more, or more than four times the amount of money an investor would have had by investing just in the S&P 500. That is the power of compounded returns over the long term, and it doesn’t require a five-percentage-point annual difference; even earning an extra percentage point or two a year – or paying an extra percentage point or two less in annual fees – can really pay off.

But wait! These returns are measured in the period from right before Lynch’s reign to today. How has Magellan performed since Dec. 31, 1990, right after Lynch’s departure?

Fund Avg. Annual Return Total Cumulative Return $10,000 Turned Into…
Magellan 8.2% 455.9% $55,587
Vanguard 500 9.1% 569.0% $66,894

This brings us to…

Principle #1: A fund’s return is only as good as its manager

As you can see, Magellan has not been able to repeat its stellar performance once Lynch left. Investors would have been better off in an index fund since 1990. Once a management team leaves a fund, its past performance is meaningless. In Magellan’s case, the fund’s performance – relative to the S&P 500 as well as its peers – has steadily gotten worse. According to Morningstar, the fund has underperformed 95 percent and 79 percent of similar investment funds over the past 10- and 15-year periods, respectively, and underperformed the S&P 500 by an average annual 3.0 percent and 1.8 percent, respectively.

Which brings us to…

Principle #2: Fund managers with great records don’t always maintain their greatness

In 2005, Fidelity put Harry Lange in charge of Magellan. He has worked at Fidelity since 1987, and had great success managing the Fidelity Capital Appreciation Fund. But Magellan’s relative performance continued to decline, getting spanked by 94 percent and 96 percent of its peers over the past three- and five-year periods, respectively, and underperforming the S&P 500 by an average annual 5.7 percent and 4.8 percent, respectively.

There are many reasons for Lange’s lagging, including buying financial stocks right before the crash of 2008. But another reason brings us to…

Principle #3: Once a fund gets popular, and bigger, returns suffer

Due to Lynch’s success managing Magellan, money poured into the fund. Once a fund gets bigger, the universe of stocks it can buy shrinks. A huge fund can no longer choose from among the thousands of smaller stocks without itself driving up stock prices with millions of dollars’ worth of purchases. It is then relegated to choosing from among a few hundred multibillion-dollar companies, which historically have not performed as well as smaller companies.

Despite Magellan’s size being 14 percent of its peak size, it’s still a huge fund. Which is a fine segue to…

Principle #4: Don’t fall prey to inertia

Of the 2,299 distinct domestic stock funds in the Morningstar database, Magellan is No. 36 on the size list. Despite its lousy performance over the past few decades, many people are still invested in it – perhaps millions of them. I’m not sure why, but my guess is that one of the biggest reasons is inertia, as suggested by financial planner and columnist Allan Roth (one of my favorite financial writers). People invested in the fund, perhaps due to its long-ago extraordinary performance and its association with super-investor Peter Lynch. Today they just aren’t aware of its underperformance or haven’t taken the initiative to move their money.

And now, the final lesson.

Principle #5: Regularly monitor the performance of your funds

Once a year, visit to see how your funds are performing relative to similarly invested funds and relevant benchmarks. Even great funds will have a bad year or two, so check the performance over periods of three and five years. Unfortunately, you’ll likely find that many, if not most, of your funds will underperform index funds that choose from the same types of investments, since history says that the majority of actively managed funds lose to index funds. If your fund is among the stinkers, look for another option.

Run from this zombie!

In honor of Halloween, I hereby declare Magellan a zombie fund – one that should have died decades ago, but keeps on living, eating more and more of investors’ potential wealth. A year ago, Fidelity replaced Harry Lange with Jeffrey Feingold as Magellan’s manager, and the fund has outperformed 81 percent of its peers – but still lost to the S&P 500 by 1.5 percent. Given Fidelity’s inability to find a successful replacement for Peter Lynch and resurrect Magellan’s performance, investors will likely add more life to their finances by getting all Rick Grimes on this portion of their portfolios.

Final note: Happy birthday to my sister Karen, who despite being born on Halloween is one of the sweetest, reliable, and least-scary people I know.

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