A mutual fund is a pool of money managed by a professional investment advisory firm on behalf of individual investors who have purchased shares of the fund. The fund buys securities to pursue a stated investment strategy. By investing in the fund, you own a piece of the total portfolio of securities, which provides most investors with both a convenient way to obtain personal money management and instant diversification that might be difficult to achieve otherwise.

Types of mutual funds
There are many mutual funds to choose from. The three most common types are stock mutual funds, bond mutual funds and money market mutual funds.

A stock fund invests in common stocks issued by U.S. and/or international companies. A bond fund is made up of debt instruments that governments or corporations issue to raise capital.

A money market fund buys extremely short-term debt instruments and is often used as a risk-adverse vehicle in which to park cash.

Funds that invest in a combination of stocks, bonds and money markets are also referred to as balanced funds or growth and income funds. Mutual funds that attempt to replicate a standardized, broad-based index such as the Standard and Poors 500 (S&P 500) stock index are referred to as index funds.

What are the benefits of investing in a mutual fund?
Diversification: Most mutual funds own dozens or even hundreds of securities. This exposes an investor to less potential risk than buying just a few individual securities. If some of the fund's holdings perform poorly, they may be offset by others doing well.

Professional money management: Full-time expertise is part of what investors pay for when purchasing mutual fund shares. The fund analyzes hundreds of securities, and makes decisions on what and when to buy and sell.

Small investment amounts: Depending on the fund in question, an investor can open an account and make subsequent contributions, sometimes with as little as $1,000 and/or with a $50 per month automatic bank draft investment.

Liquidity: Shares of most mutual funds may easily and quickly be redeemed for cash by making a request to the fund company in writing, over the phone, or even via the mutual fund’s website on any business day. However, because the price of the mutual fund’s shares is only set once, at the end of each day’s trading, share prices may have appreciated or decreased in value after an investor placed an order to buy or sell.

Choosing the right fund
Choosing a mutual fund requires careful thinking about numerous factors. The most important include your investment objectives, risk tolerance and time horizon. A mutual fund’s prospectus provides a great deal of information, such as the fund's investment objective expenses. A financial advisor may be of great assistance.

Sales charge and other costs
All mutual funds have expenses that investors must pay. A sales charge, also known as a “sales load,” is generally paid as commission to stockbrokers, financial advisors and insurance agents. The sales charge may be deducted at the time you purchase shares of the mutual fund (front-end load), leaving less to invest, or it may be charged at the point of redemption (back-end load). Some mutual funds, known as no-load funds, have no front or back-end charges.

Investors also need to pay attention to a mutual fund's other fees and expenses as well. Look at a fund's expense ratio, which is calculated by dividing the fund’s annual expenses by the fund's average net assets. Expenses impact a fund's return. The higher the expense ratio, the more likely the fund's return will be lower than that of a similar fund with lower expenses.

Turnover rate
Portfolio turnover reflects the average length of time that a security remains in a fund's portfolio. If a fund has replaced its entire portfolio during the course of the year, its turnover rate would be 100 percent.

High turnover rates generally add to the expenses of a fund (reflected in the expense ratio). More important, however, is that when the fund sells stock for a gain, the investor will incur a taxable event, even if the gain was reinvested.

A tax-efficient approach minimizes the tax effect by implementing strategies such as offsetting gains by selling other stocks at a loss or holding stocks for long periods. Note that if you own a mutual fund in an individual retirement account (IRA) or a qualified retirement plan at work (e.g., a 401(k)), tax efficiency is not as important. This is because no tax is immediately paid on realized gains in these retirement accounts and plans; tax is deferred until the money is withdrawn.

Past performance
Although past performance is no guarantee of future results, a fund’s track record over the past 3, 5, and 10 years is certainly worth considering. How does it compare with its peers--funds with similar risk and investment strategies? Apples-to-apples comparisons of funds are difficult, so a variety of broad market indexes are used as comparison benchmarks. For example, the S&P 500 is often used as a proxy for the U.S. stock market as a whole. Relative to the S&P 500, examine how well the fund that you are looking at has performed.

Fund managers
One of the advantages of purchasing mutual fund shares is professional money management. The past performance of the fund is a reflection of the fund manager’s ability to effectively manage its assets. You should research the current manager’s history with the fund; was the fund’s performance his or her achievement? If the fund has a new manager, make sure that his or her investment style matches your expectations.