A mutual fund is like a basket of investments; a single mutual fund can hold thousands of different stocks and bonds, enabling you to invest in all of them by purchasing a single share of the fund. For this and other reasons, mutual funds are the perfect way to begin investing.

I hope youll read this post, but Im nervous you may not.

Why? Because the word “mutual fund” is in the headline. I mean, really, even if you’re into investing, talking about mutual funds is about as exciting as watching a turtle cross the road.

But in recent reader polls, lots of people tell me they want more coverage on investing topics like understanding the basics and transitioning from just saving money to actually investing it. And in my opinion, mutual funds are one of the best ways to start investing even if you don’t know a lot about investing. Unfortunately, however, you do need to know a little bit about mutual funds to avoid putting your money into the wrong mutual fund. Does that make sense?

I’m kicking off a four-part series on mutual funds. Today I’ll provide a very basic overview on mutual funds for true beginners and how you can use them to start investing. Then we’ll sink our teeth into some stuff intermediate investors can use as well.

Here are the topics:

Sound good? Let’s go.

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WHAT IS A MUTUAL FUND?

A mutual fund is a type of professionally-managed investment that pools your money with other investors. The fund’s managers then use the pooled money to buy securities for the group. A mutual fund’s primary advantage is that it provides automatic diversification and should be less volatile. (For example, if a mutual fund holds 100 stocks and one of those stocks becomes worthless, you only lose 1% of your money. If, by contrast, you only owned that single stock, you would’ve lost all of your money.)

For most individual investors, mutual funds provide the easiest way of maintaining the right mix of investments. To achieve the same thing on your own you need 1) a lot of money to invest and 2) lost of time to manage your investments.

On the downside, mutual funds have costs that can eat into your investment returns. Sophisticated investors may also find that mutual funds offer less control over the timing of gains and distribution of income.

TYPES OF MUTUAL FUNDS

Mutual funds provide an easy way to invest for any type of goal (short or long term) with almost any amount of money. (You can find mutual funds to invest in with as little as $50 if you make automatic monthly investments or $500 in a one-time investment). The bad news is that choosing a mutual fund can be overwhelming. Morningstar. the leading source of mutual-fund research, tracks over 15,000 funds. How do you pick? First, you narrow the field.

There are many types of mutual funds:

• Open-end and closed-end funds.
• Actively-managed and index funds.
• Stock funds, bond funds, REIT funds, commodity funds, and more.
• Target date funds.
• Small-cap, mid-cap, and large-cap funds.
• Growth funds and value funds.

Head spinning yet? Take a deep breath. Here’s what you need to know.

Open- vs. closed-end funds

Most funds you’ll be interested in are open-end mutual funds, meaning they will continue to issue shares as long as investors want to buy them.

Active vs. passive funds

Most mutual funds are actively managed, meaning a manager or a team of people monitor the fund performance and routinely adjust the fund’s mix of investments based on their research and experience in an attempt to beat the return of the overall market. By contrast, index mutual funds or passive funds simply hold a fixed ratio of investments to track the entire market or a portion of the market. The advantage to these funds is they have significantly lower fees.

Target-date mutual funds

These mutual funds are designed to make investing for retirement (or other goals) super simple. You select the fund based on the year closest to when you want to retire. For example, if you’re 25 in 2011 and want to retire at 65, you would invest in a 2050 target date fund. The fund’s managers then automatically rebalance the fund’s investments based on that date, growing more conservative as you get older.

HOW TO INVEST IN A MUTUAL FUND

Buying shares of a mutual fund is easy; there are a few ways to go:

If you have a 401(k) or other retirement plan at work, chances are you already own a mutual fund or two. The easiest way to invest in mutual funds is to select one within your 401(k) or other employer-sponsored retirement account.

Brokerages

You can buy and sell mutual funds through any online stock broker.

Online brokerages provide the easiest way to trade any kind of investmentmutual funds, exchange-traded funds, stocks, bonds etc. They also offer lots of free research tools. The downside is that they charge commissions every time you buy or sell shares of an investment. This can get expensive, especially for new investors.

Direct investing

You can open a mutual fund account or IRA directly with a mutual fund company. (These include Vanguard. Fidelity. TIAA-CREF. T. Rowe Price. and many others.)

The good thing about investing this way is that you won’t have to pay a trade commission to buy or sell shares of your mutual fund, and most fund companies have automatic investing plans allowing you to start investing as little as $50 a month.

The downside to investing directly with a mutual fund company is that you’re limited to that company’s mutual funds. So if you someday want to invest in other company’s funds or buy individual stocks, you will have to open a second account somewhere else. (There are some exceptions. Fidelity and Vanguard, for example, have brokerages.)

If you’re new to investing, I recommend making regular monthly contributions directly to a mutual fund. If you’re saving for retirement, set up a Roth IRA account. If you’re saving for a shorter-term goal, set up a regular, taxable mutual fund account.

This approach (called dollar cost averaging for investing nerds) has two benefits:

• When you enroll in automatic investing directly with a fund company, you avoid per-transaction trade commissions.
• By purchasing the fund in small monthly increments (rather than as a lump sum), you take advantage of ups and downs in the market. This eliminates the risk that you’ll buy a lot of shares at a high price. Using dollar cost averaging you’ll purchase more shares at lower prices and this will give you a better return over time.

Next week, we’ll take a look at choosing mutual funds. First we’ll talk about the cost of mutual funds —a critical factor that even seasoned investors sometimes overlook. Then we’ll cover all the factors you should consider when choosing a mutual fund. In the meantime, if you have any general questions about mutual funds, drop me a note in the comments and I’ll do my best to answer them either here or in a future post.