When I started my first cover band several years back, my thought was the same as yours: "Play what I want to play, and if it sounds good, people will listen."
But it doesn't really work that way...
That doesn't mean you can't play stuff you like, or that you won't enjoy what you're playing, or that you can't have fun with an audience! You just have to figure out the right cocktail of tunes.
A couple years ago I found my way into a popular area gigging rock band as the lead guitarist, playing stuff like Judas Priest, Van Halen, Motley Crue, Ozzy, etc. That band was the best band I've ever played in - we were tight, sounded great, played packed shows, and people DANCED!
We were really two bands in one: A heavy rock band for headbangers and such, and a dance band. We wanted to "rock out", but we wanted people to dance and have a good time.
To do that, we had to pick songs that matched our goals. Tunes like "Bad Girlfriend" and Nickleback's "Figured You Out" rock plenty hard enough, but still get chicks on the dance floor (and you know where the women go, the men follow).
We crafted our sets such that the best "rock" dance tunes were sets 2 and 3, during the middle hours of the night when everyone wants to be on the dance floor. We saved our heaviest stuff, which was not so dance friendly, for the final set, when most of the dancers have gone home, but the hardcore drinking metalheads remain, and will totally rock out with you.
It worked.
This band packed 'em in at the bars (and still does). Mostly people who come to the shows are age 35-50 add are fans of 80's and 90's rock. Biker types, etc.
And people dance. Which is really cool.
At the same time, we had a lot of fun songs to play. I think there were only a couple songs in the entire 44-song set list that I didn't enjoy playing. Everything else was fun, and some stuff, for a lead guitar player like me, was the kind of stuff I lived to play (Crazy Train, Enter Sandman, Bark at the Moon... I mean, that stuff was challenging and fun to play).
The trick, for us, was to re-examine our set lists after every show. We would give a song 3-4 shows before completely ditching it. Sometimes all it would take is moving it around to a different spot on the set list. Maybe a song stinks in set 2 or 3 and causes people to leave the dance floor, but maybe it really works in set 1 (when everyone is just starting to liquor up) or set 4 (when everyone is well-oiled and ready to throw their fist in the air).
We were constantly evaluating our songs and bringing in new material until our 2nd and 3rd sets were so good we stopped fiddling with them. We had two sets worth of material where people would dance non-stop... And that was part of our goal.
So, my advice would be: always evaluate how your songs go over with a crowd. You may LOVE a certain song, but if it doesn't connect with a crowd, you're wasting their time. Stephen King has a line in his "On Writing" book about story elements and characters that don't further the story. He tells prospective authors: "Kill your darlings". Take them out of the book, off the page, because they don't work.
You have to do the same thing with songs. If a song doesn't work, it doesn't matter how much you enjoy playing it or how well you all sound together playing it. If it doesn't work, it doesn't work. You have to eliminate it. Be ruthless with your songs and you will find that your set lists evolve into something that really connects with the audience.
That said - I'd also offer one last piece of advice: Don't play songs you absolutely HATE. That was kind of our rule as well. There's enough songs in the universe that you do NOT have to play something just because every other cover band does. My personal rule has always been that I will never, ever, under any circumstance, play "Sweet Home Alabama". And I never have. I hate that song so bad I cannot even begin to describe my dislike for it.
Everyone in our band had veto power. If someone absolutely didn't want to play a song, we didn't do it. You should have the same sort of rule. You never want to play songs that people in the band just "HATE" playing. That sucks the fun out of the night.
So find a balance. A balance between what you want to play, what you can live with playing, and what connects with the audience.
There is no sure-fire formula or magic set list. It's a journey. You'll figure it out over time.
Enjoy!