Mutual Funds Basics

Have you ever tested the water temperature by dipping in a single toe? For decades, mutual funds have offered hesitant investors a chance to enter the stock market without risking overconcentration in any single security. If you've been thinking about mutual funds, educate yourself on the essentials before you plunge into the investing pool.

Financial advisors frequently tell their clients to avoid "putting all their eggs in one basket." This same advice is helpful when investing in the stock market. Mutual funds are groups of combined investments controlled by a fund manager (sometimes also called a money manager). Rather than buy individual stocks or bonds, mutual fund investors buy shares of a mutual fund that invests in many different stocks and/or bonds.

How they work

Let's say, for example, that you're interested in investing in utilities stocks. You've heard that they perform well, even in a down market, and you're ready to buy.

But hold on just a minute. How do you know which company to buy? It's unwise to put all of your money into a single stock, no matter how promising it is. What if it tanks?

By purchasing a utilities mutual fund, however, you could still invest in that sector without risking your entire piggy bank on one promising company. Many mutual funds are available for an initial investment of $500 or less. Instead of owning a fraction of one company, you could invest in a fund that contains 20, 30, or potentially hundreds of individual stocks.

The idea is this: if one stock performs poorly, the loss will be mitigated by other stocks in the fund that perform well. Mutual fund managers continually "rebalance" their fund offerings in order to weed out the losers. You can still lose money on your investment, but mutual funds allow you to hedge your bets in a way that individual stock investments can't.

Purchasing mutual funds

You could buy your first mutual fund directly from the fund company, but if you're a new investor, you may want to meet with an investment broker who'll do the market research for you and help you get started.

Many funds enforce sales charges of 5 percent or more, either up front, or when you sell the investment. You can avoid this charge by looking for no-load funds that don't charge this fee.

Bond Funds

If safety is your primary concern, bond funds may be the way to go. Although experts believe that bonds are safer than stocks, they still carry risks relative to interest rates, market volatility, and ease of liquidity.

You can minimize these risks by buying a bond fund instead of an actual bond. Your exposure will be spread across an entire group of balanced investments, and you'll earn steady income. You can reinvest this income or have it paid to you in regular installments.

Mutual funds are a great way to ease into the market without committing yourself 100 percent. But swimming in these sometimes murky waters can be complicated, so make sure that you understand the basics before you dive in.