Stocks represent part ownership, or equity, in corporations, and the goal of stock ownership is to see the value of the companies increase over time. Stocks are often categorized by their capitalization (or market cap) and, like many other things, come in three basic sizes: small, medium, and large. Many mutual funds invest primarily in one of these sizes and are thus classified as large-cap, mid-cap, or small-cap funds. Additionally, mutual funds are often categorized by the type of stock that is bought. Mutual fund types are generally growth, value, or a combination of the two, called blend.

Balanced funds mix some stocks and some bonds. A typical balanced fund might contain about 50-65% stocks, and hold the rest of the shareholders money in bonds and cash. It is important to know the distribution of stocks to bonds in a specific balanced fund to understand the risks and rewards inherent in that fund.

Global and international funds invest in companies whose homes are beyond the fair shores of this great nation. (There are, of course, many other great nations.) In general, international funds are much more volatile than domestic funds. International funds generally invest only in foreign companies, while global funds may invest in some U.S.-based companies in addition to foreign companies.

Sector funds invest in one particular sector of the economy: technology, banking, computers, the Internet, llamas. Just kidding about the llamas. No one has yet started the Llama Fund, though its only a matter of time given that there is a mutual fund called the Couch Potato Fund, which invests in, as far as we know, the remote control sector. Sector funds can be extremely volatile because the broad market will find certain sectors very attractive and very unattractive often in rapid succession (much like couch potatoes may find certain programs very attractive and very unattractive in rapid succession — annoying the heck out of their significant others).

Finally, our favorite, the index mutual fund, owns a full participation in some portion of the stock market. An index fund matches the shareholdings of a target index, such as the Standard Poors 500 Composite Stock Price Index (SP 500). Index funds are distinct from actively managed mutual funds in that they do not involve any stock picking by supposedly skilled professionals — they simply seek to replicate the returns of the specific index. The Motley Fool Index Center offers a complete description of some of the major indexes you may have heard of.

We know you probably don’t want to spend hours learning about the intricacies of mutual fund investing. Even if you’ve cleared your calendar for some quality fund study time, we don’t need to dominate your afternoon with this topic. So, here are seven words that’ll serve as the foundation — heck, make that the foundation, walls, roof, and wall-to-wall shag — for your long-term success in investing in mutual funds:

If in doubt, buy an index fund.

There you have it! Thankyouverymuch, ladies and gentleman! We’re here every Friday. Please remember to tip your waiters and waitresses.

Still here? All right. You caught us trying to sneak out of work early on a sunny day. Mutual funds are a hot commodity with individual investors and financial institutions, with trillions of dollars invested in them.

With so much money riding on the success of mutual funds, how can we be so pat with our breezy summation? Well, the fact is that most investors can be perfectly comfortable buying an index fund — which is simply a mutual fund that tracks some stock market index, whether it’s the Standard & Poor’s 500 Stock Index, the entire stock market index, or some other performance measure of a like group of stocks.

Before we get into that, first, a little background.

What are mutual funds?

A mutual fund is simply a collection of stocks and/or bonds. Mutual funds are financial intermediaries — they are set up to receive your money and then make investments with the money. Most mutual funds are actively managed, meaning the mutual fund shareholders, through a yearly fee, pay a mutual fund manager to actively buy and sell stocks or bonds within the fund. When you buy mutual fund shares, you are a shareholder — an owner — of that mutual fund, with voting rights in proportion to your ownership of the fund.

The price of active management

Though you would think that mutual funds provide benefits to shareholders by hiring expert stock pickers, the sad truth of the matter is that over time, the vast majority — approximately 80% — of mutual funds underperform the average return of the stock market.

Why the underperformance? The toughest job an active manager has to do is to overcome the higher costs of an actively managed fund. Many simply aren’t up to the task.

What does this mean for you?

In simplest terms, you can’t afford to pay for fund managers that don’t earn their fees. If a fund has fees of 2% and only matches the market with its stock picks before paying those fees, then you’ll end up with a return that’s 2% less than the market’s, year after year.

Although 2% may not sound like that big of a deal. it represents nearly a fifth of the market’s long term average return of around 10%. Put another way, over 50 years, a $10,000 investment will compound to $1,170,000 at 10% returns per year, but to only $470,000 at 8% per year.

Uh-oh, now what?

You need to pick your funds carefully. For the most part, picking a fund is just like investing in individual stocks. You might be happy with an index fund. But what if your 401(k) doesn’t offer an index fund? Or what if you already own an index fund but want to add some diversity to your portfolio? Or, perhaps you wonder: I’ve heard plenty about mutual funds that beat the pants off your namby-pamby index fund. How do I get me one of those?

Well, there are some funds — or, more precisely, some fund managers — whose services are worth paying for, because they are superior investors who are simultaneously fee-conscious. You just have to find them and know what the heck everyone is really talking about.

Pick a Winner!

All there is to picking the right mutual funds is learning what to look for. We offer some general guidelines, as well as some hands-on resources, to help you find winning funds for your portfolio: