If you snoop around the fool a little more, you will learn a on how a vast majority of mutual funds dont come close to beating the market each year or over a large period of time.

Actually, if you snoop around the web in general, you'll find that this statement is only partially correct. A good place to start is:

http://www.schwab.com/SchwabNOW/SNLibrary/SNLib123/SN123Article/0,5637,872%7C3368,00.html

Only about 22% of large cap mutual funds outperform the S&P 500 index funds (but that's still a significan number of funds). However, about 63% of small cap mutual funds outperform the Russell 2000 index funds. So you have to look at where you want to invest your money and how much effort you are willing to expend in research, selection, and monitoring of your investments.

I know a number of people who have been invested in index funds for a number of years and were just devastated when over 30% of their asset value disappeared on them last year. Even though they aren't planning on receiving distributions from their funds for some time yet, it was still traumatic to watch it happen. And when they compare their losses to my gains during the same period of time, they bemoan ever having gone into index funds.

There are no sure things in the market. Each investor has to assess their own psychology, risk aversion, and goals and act accordingly.

Also, a regular mutual fund cant hold a small number of stocks.

This statement is, again, only partiall true. It depends on the size of the fund and the size of the companies in which they invest. A mutual fund must own stock in at least 20 companies since they are not allowed to INVEST more than 5% of the total value of the fund in any one company. (If the stock in a company APPRECIATES to the point where it compromises more than 5% of the fund's holding, the fund doesn't have to liquidate any of the holding; they are prohibited from INCREASING any holding beyond the 5% limit). And funds are prohibited (to the best of my knowledge) from owning more than 10% of any one company. So these factors definitely cause problems for monster funds like Fidelity Magellan but are no problem for the Jensen Fund (which only owns around 26 stocks at any given time).

In picking funds, the overall considerations should be consistency of returns and size of these returns. As Peter Lynch points out in Beating The Street (page 62 as I recall) "forget about expense ratios". The money represented by the expense ratio has already been subtracted out before the fund's yield is computed. So a fund with a CONSISTENT, long term yield of 15% with an expense ratio of 3.2% is far superior to an index (or other) fund with an AVERAGE yield of 11% and an expense ratio of only 0.2%. Yields on index funds are hardly consistent, since they fluctuate just as wildly as the index on which they are based.

Enhanced index funds can be worth looking into. Instead of investing in ALL of the funds in an index, they maintain their holdings in whatever segment of the index is currently performing well. You might call these "semi-managed" funds. Their expenses are usually lower than the "fully managed" funds, and they have more turnover, but the overall philosophy is akin to regular index funds.