Mutual funds are a way for investors to pool their money so they can invest in many different stocks or bonds. Each investor is charged a percentage of his investment as a fee to pay for the expenses of having a professional fund manager and all the costs associated with researching, buying, and selling stocks. Mutual funds are the best alternative for most people for several reasons:

• They automatically diversify your portfolio among a larger number of stocks than you could achieve by purchasing individual stocks.

• Some funds invest in stocks, bonds, and cash equivalents, which gives you even greater diversification.

• They require only a small amount of money to get started, sometimes as little as $25.

Like stocks, some mutual funds are riskier than others, so be sure to read the fund's objectives and know what it invests in. Will your money be buying stocks in blue-chip companies or in the corporations of developing countries? Although past performance is no guarantee of the future, look at how the fund has done over the last several years and compare it to an applicable index to see if it kept pace with its competitors. Also consider the expense ratio (the costs of owning the fund). The lower it is, the more of your return you get to pocket.

Risk Level of Mutual Funds

Mutual funds tend to be less risky than individual stocks because their investment in any one stock is relatively small compared to their entire holdings. If one company takes a nosedive, the effect on the fund is usually minimal, or at least diluted. When entire sectors, such as technology stocks, head downhill, the impact can be great if the fund is heavily invested in technology stocks.

Income Versus Growth

Different funds have different investing objectives. Funds whose objective is current income invest heavily in bonds because of the steady interest income they generate. These funds appeal to retirees and those on a fixed income. Funds whose objective is long-term growth invest in stock, stock mutual funds, and real estate because those investments usually increase in value over time. Growth and income funds are a hybrid of these two types and invest in both kinds of securities.

Load and No-Load Funds

Load is a sales fee or commission charged by some mutual funds, and is usually stated as a percentage of the amount purchased or sold. Front-end loads are fees charged up-front when you buy the fund. Back-end loads are fees you pay when you sell the fund. If the load is 6 percent and you invest $2,000, the load will be $120. Funds that don't charge front-end or back-end loads are called no-load funds. When choosing a mutual fund, consider the load, if any, and the annual expense ratio. These eat into your return. If you buy a fund with a 6 percent load and a 2 percent expense ratio, you have to earn an 8 percent return the first year before you break even.

Loads typically go (in part) to an advisor or broker who sells you the fund. If you're paying a load, you're paying somebody for advice. That's fine if you are getting valuable advice — but don't pay a load unless you're getting something out of it. Also, beware of “back- end” load products. Sometimes it's hard to tell that you're paying a sales charge because you don't see it up-front.

Index Funds

If you don't want to spend a lot of time keeping up with the financial status of the companies you're invested in, and you don't want to pay a manager to pick stocks, a stock index mutual fund is the best choice. Interestingly, most professionally managed funds underperform the stock market in general, which is why some financial advisors recommend that their clients buy index stock funds. An index fund's objective is to match the return of a specified index by buying shares in each stock in that index.

Market Capitalization

Mutual funds are classified based on the market capitalization of the companies they invest in because cap is one of the criteria investors look at when choosing funds. A company's cap is calculated by multiplying the current stock price times the number of outstanding shares of stock. The categories are:

• Large-cap funds: Companies with market capitalization over five billion dollars.

• Mid-cap stock funds: Companies with market capitalization of one to five billion dollars.

• Small-cap funds: Companies with market capitalization of 250 million to one billion dollars.

• Micro-cap funds: Companies with market capitalization of less than $250 million.

The large-cap funds, such as Vanguard's 500 Index, are considered the least volatile and the smaller company funds are considered the most volatile.

How to Buy Mutual Funds

You can use full-service or discount brokers to buy mutual funds, or you can buy directly from a family of mutual funds, such as Vanguard (www.vanguard.com) or Fidelity (www.fidelity.com). Call the company's toll-free number or request an investor's kit online, fill out the forms, and send them in with your check. You can initiate this procedure on the mutual fund's Web site, but you'll still have to send in your check, unless you want to transfer the money electronically.