Faced with a bewildering assortment of investment choices, millions of investors have turned to mutual funds as the investment of choice for their retirement savings. Why? Because mutual funds allow investors to easily assemble a diversified portfolio of stocks and bonds at a reasonable cost.

For more than two decades , SMI has used such funds — with great success — as the basis of our model portfolios.

The story is told of the time Abraham Lincoln received an invitation to deliver a college commencement address. Because the exact date had not yet been set, the college inquired as to how much notice Mr. Lincoln would need to have time to prepare. "The answer" he said, "depends on how long you wish me to speak. If you want me to talk for just 15 minutes, I'll need three weeks' notice. If it's for an hour, I'll need only three days' notice. If you'll let me speak all day, I can start right now!"

The point behind Mr. Lincoln's humorous answer is that to be economical in one's presentation, while still covering all the essentials, requires a great deal of preparation. I thought of Lincoln as I was reviewing all the books in my investment library written solely on the subject of mutual funds. I have 26 such books; they average more than 250 pages each! Can I hope to teach you more about mutual funds than is already covered in those 26 books? Probably not, especially when you consider that they run collectively to more than 6,500 pages!

So I'm going to do something that may be even more valuable — teach you less. I'm going to mercifully leave out a lot of material best reserved for a more in-depth study, and instead focus only on those things you need to know about mutual funds to benefit from them. Put that way, there really isn't much to learn! This article will serve as a primer, and a primer teaches only the basics.

One thing more before we begin. The fund industry has experienced explosive growth over the past 30 years. The sheer number and types of different funds (more than 8,500 currently) is overwhelming. As a result, I find that many people feel confused, if not intimidated, by the whole topic. That can be a problem for SMI readers because all of our investing strategies rely heavily on mutual funds. But take heart! This primer has been written especially for you beginners. Remember, what you really need to know about mutual funds is not all that detailed. Ready? Let's get started!

The easiest way to understand a mutual fund is to think of it as a big pool of money. The Barron's Dictionary of Finance and Investment Terms defines a mutual fund as a "fund operated by an investment company that raises money from shareholders and invests it in a variety of securities." My plain-English definition is that it's (1) a big pool of money (2) collected from lots of individual investors (3) that is managed by a full-time professional investment manager (4) who invests it according to specific guidelines. When you put money in a mutual fund, you are pooling your money with other investors in order to gain advantages normally available only to the wealthiest investors. You are transformed from a small investor into part-owner of a multimillion-dollar portfolio!

What do you get in return for your investment dollars? You receive shares that represent your ownership in part of the pool. The value of the shares is calculated anew at the end of each day that the financial markets are open.

Here's how it's done. First, you take the day's closing market value of all the investments in the fund's pool. To that number, you add the amount of cash on hand that isn't invested for the time being (most funds keep 3%-5% of their holdings in cash for day-to-day transactions). That gives you the up-to-the-minute value of all the pool's holdings. Next, subtract any amounts the pool owes (such as management fees that are due to the portfolio manager but haven't yet been paid). This gives the net value of the assets in the pool. Finally, you divide the net value by the total shares in the pool to determine what each individual share is worth. This is called the net asset value per share and is the price at which all shares in the fund will be bought or sold for that day. It is also the number that is reported in the financial news media.

What kinds of securities do mutual funds invest in?

That depends on the ground rules set up when the pool was formed. Every mutual fund is free to make its own ground rules. The rules are explained in a booklet called the prospectus that every mutual fund must provide to investors — that is where you learn which types of securities the fund is allowed to invest in.

In this article, I'll be using examples that might give the impression that mutual funds invest only in stocks. This is not the case. Mutual funds invest in just about every type of security around, including corporate, government, and tax-free bonds, federally-backed mortgages, and money market instruments such as bank CDs, commercial paper, and U.S. Treasury bills. For the average person, mutual funds are the best way to assemble a well-balanced, diversified portfolio containing many different kinds of securities. But to simplify things, I'll primarily use mutual funds that are stock-oriented when I'm explaining how funds work.

A mutual fund will usually limit its investments to a particular kind of security. For example, assume you want to invest only in quality blue-chip stocks that pay good dividends. As it turns out, there are a large number of mutual funds whose rules permit them to invest only in such stocks. No small company stocks, stock options, long- or short-term bonds, precious metals, or anything else. By limiting their permissible investments, mutual funds allow you to pool your money together with the dollars of thousands of other investors who wish to invest in similar securities.

Mutual funds are almost certain to play an important role in your financial future because they offer many benefits that will make your investing program easier and safer. Here are 20 of their major advantages.

Advantage #1: Mutual funds can reduce the anxiety of investing.

Most investors live with a certain amount of anxiety and fear about their investments. This is usually because they think they lack one or more of the following essentials: (1) market knowledge, (2) investing experience, (3) self-discipline, (4) a proven game plan, or (5) time. As a result, they often invest on impulse or emotion. The advantages offered by mutual funds go a long way toward relieving the anxiety often associated with investing.

Advantage #2: Mutual fund shares can be purchased in small amounts, which makes it easy to get started.

If you have been putting off starting your investing program because you don't know which stocks to invest in and you can't afford your own personal investment consultant to tell you, mutual funds will get you on your way. It doesn't require large sums of money to invest in mutual funds. Most fund organizations have minimum amounts needed in order to initially open your account, which usually run from $1,000 to $3,000. And if that's too much, most funds have much lower minimums for IRAs and "automatic deposit accounts" where you agree to make regular monthly deposits to build your account.

Advantage #3: Mutual fund accounts can also be added to whenever you want (often or seldom) in small amounts.

After meeting the initial minimum (if any) to open your account, you can add just about any amount you want. To make your purchase work out evenly, fund companies will sell you fractional shares. For example, if you invest $100 in a fund selling at $7.42 a share, the fund organization will credit your account with 13.477 shares ($100.00 divided by $7.42 = 13.477).

Advantage #4: Mutual funds reduce risk through diversification.

Stock funds typically hold from 50 to 500 stocks in their portfolios; the average is around 180. They do this so that any loss caused by the unexpected collapse of any one stock will have only a minimal effect on the pool as a whole. Without the availability of mutual funds, the investor with just $3,000 to invest would likely put it all in just one or two stocks (a risky way to go). But by using a mutual fund, that same $3,000 can make the investor a part-owner in a very large, professionally researched and managed portfolio of stocks.

Advantage #5: Mutual funds are able to take advantage of economies of scale (volume discounts).

Mutual funds are able to pay less per trade than individuals. But the big advantage here isn't that they pay, say, $5 per trade while you would have to pay $10. It's that your $10 trade represents 0.1% of the value of a $10,000 personal portfolio, whereas the same trade might only represent 0.00000001% of a typical mutual fund's portfolio value. By pooling your money with thousands of other investors, you're only paying for a tiny fraction of the commissions generated by the fund.

Advantage #6: Mutual fund price movements are far more predictable than those of individual stocks.

The extensive diversification of most funds, coupled with outstanding stock selection, makes it highly unlikely that the overall market will move up without carrying almost all stock mutual funds up with it. For example, the strongest market day in 2012 thus far occurred on March 13 when the Dow Industrials jumped 218 points. More than 95% of stock mutual funds were up for the day. Yet, of the more than 3,000 individual stocks that traded on the New York Stock Exchange, about 78% ended the day with a gain. The rest, almost one in four, ended the day unchanged or actually fell in price.

Advantage #7: Mutual funds' past performance is a matter of public record.

Advisory services, financial planners, and stockbrokers have records of past performance, but how public are they? And how were they computed? Did they include every recommendation made for every account? Mutual funds have fully disclosed performance histories, which are computed according to set standards. With a little research, you can learn exactly how the various mutual funds fared in relation to inflation or other investment alternatives.

Advantage #8: Mutual funds provide full-time professional management.

Highly trained investment specialists are hired to make the decisions as to which stocks to buy. The person with the ultimate decision-making authority is called the portfolio manager. The manager possesses expertise in many financial areas, and hopefully has learned—through experience—to avoid the common mistakes of the amateur investor. Most important, the manager is expected to have the self-discipline necessary to doggedly stick with the mutual fund's strategy even when events move against him for a time.

Advantage #9: Mutual funds allow you to efficiently reinvest your dividends.

If you were to spread $5,000 among five different stocks, your quarterly dividend checks might amount to $2.50 from each one. It's not possible to use such small amounts to buy more shares without paying very high relative commissions. Your mutual fund, however, will gladly reinvest any size dividends for you automatically. This can add significantly to your profits over many years.

Advantage #10: Mutual funds offer automatic withdrawal plans.

Most funds let you sell your shares automatically in an amount and frequency of your choosing. This pre-planned selling enables the fund to mail you a check for a specified amount monthly or quarterly. This allows investors in stock funds that pay little or no dividends to receive periodic cash flow.

Advantage #11: Mutual funds, in essence, provide you with individual attention.

It has been estimated that the average broker needs 400 accounts to make a living. How does he spread his time among those accounts? The common-sense way would be to start with the largest accounts and work his way down. Where would that leave your $3,000 account? But in a mutual fund, the smallest member of the pool gets exactly the same attention as the largest because everybody is in it together.

Advantage #12: Mutual funds can be used for your IRA and other retirement plans.

Mutual funds offer accounts that can be used for IRAs and 401(k) plans. They're especially useful for rollovers. (This is when you take a lump sum payment from an employer's pension plan because of your retirement or termination of employment, and must deposit it into an IRA investment account within 60 days.) The new IRA rollover account can be opened at a bank, mutual fund, or brokerage house, and the money then invested in stocks, bonds, or money market securities. These rollover accounts make it possible for you to transfer your pension benefits to an account under your control while protecting their tax-deferred status. They are also useful for combining several small IRAs into one large one.

Advantage #13: Mutual funds allow you to sell part or all of your shares at any time and get your money quickly.

By regulation, all open-end mutual funds must redeem (buy back) their shares at their net asset value whenever you wish. It's usually as simple as a website visit or toll-free phone call. Of course, the amount you get back will be more or less than you initially put in, depending on how the holdings in the portfolio have done during the time you were a part-owner of the pool.

Advantage #14: Mutual funds enable you to instantly reduce the risk in your portfolio with a few clicks (or a phone call).

Most large fund organizations (usually referred to as "families") allow investors to switch from one of their funds to another via the Web or a phone call at no cost. One practical use of this feature is that it makes it easy to reallocate your capital between funds that invest in different types of asset classes (large company growth, large company value, small company growth, small company value, foreign stocks, and fixed income securities) as your goals and market expectations evolve.

Advantage #15: Mutual funds provide a safe place for your investment money.

Mutual funds are required to hire an independent bank or trust company to hold and account for all the cash and securities in the pool. This custodian has a legally binding responsibility to protect the interests of every shareholder. No mutual fund shareholder has ever lost money due to a mutual fund bankruptcy.

Advantage #16: Mutual funds handle your paperwork for you.

Capital gains and losses from the sale of stocks, as well as dividend and interest income earnings, are summarized into a report for each shareholder at the end of the year for tax purposes. Funds also manage the day-to-day chores such as dealing with transfer agents, handling stock certificates, reviewing brokerage confirmations, and more.

Advantage #17: Mutual funds can be borrowed against in case of an emergency.

Although you hope it will never be necessary, you can use the value of your mutual fund holdings as collateral for a loan. If the need is short-term and you would rather not sell your funds because of tax or investment reasons, you can borrow against them rather than sell them.

Advantage #18: Mutual funds involve no personal liability beyond the investment risk in the portfolio.

Many investments, primarily partnerships and futures, require investors to sign papers wherein they agree to accept personal responsibility for certain liabilities generated by the undertaking. Thus, it is possible for investors to actually lose more money than they invest. This arrangement is generally indicative of speculative endeavors; I encourage you to avoid such arrangements. In contrast, this is never the case with mutual funds.

Advantage #19: Mutual fund advisory services are available that can greatly ease the research burden.

Due to the popularity of mutual fund investing, there are a number of investment newsletters that specialize in researching and writing about mutual funds. The Sound Mind Investing newsletter, for example, offers model portfolios geared to your risk tolerance and stage of life. We provide specific fund buy/sell recommendations that are updated each month. Morningstar.com is also a great source for mutual fund data.

Advantage #20: Mutual funds are heavily regulated by the federal government.

The fund industry is regulated by the Securities and Exchange Commission and is subject to the provisions of the Investment Company Act of 1940. The act requires that all mutual funds register with the SEC and that investors be given a prospectus, which must contain full information concerning the fund's history, operating policies, cost structure, and so on. Additionally, all funds use a bank that serves as the custodian of all the pool assets. This safeguard means the securities in the fund are protected from theft, fraud, and even the bankruptcy of the fund management organization itself. Of course, money can still be lost if poor investment decisions cause the value of the pool's investments to fall in value.

Your three primary ways of profiting

When you make your mutual fund investment, you will receive shares to show how much (that is, what portion) of the pool you own. The value of these shares fluctuates daily according to how well the investments in the pool are doing. If the overall value of the stocks held in the pool goes up today, the value of the fund's shares will go up today. The price you pay for your shares is based on the worth of the securities in the pool on the day you buy in. Typically, the closing price is used for establishing their market value. For this reason, mutual funds are usually bought or sold only at the day's closing prices. This means that it doesn't matter what time of day the fund receives your order — early or late — you'll still get that day's closing price.

You can profit from your shares in three primary ways. First, the dividends paid by the stocks in the portfolio will be paid out to you periodically, usually quarterly. Second, if the portfolio manager sells a stock for more than he paid for it originally, a capital gain results. These gains will also be paid out periodically, usually annually. And third, when you're ready to sell your shares in the pool, you might receive back more than you paid for them.

Summary

Think of mutual funds as offering the convenience of something you're pretty familiar with: eating out! Someone else has done all the work of developing the recipes, shopping for quality at the best prices, and cooking and assembling the dinners so that foods that go well together are served in the right proportions.

For mutual funds, that's the job of the professional portfolio manager — he develops the strategy, shops for the right securities at the best prices, and then assembles the portfolio with an appropriate amount of diversification. And the analogy doesn't stop there. Just as there are many different dinner entrees to choose from at most nice restaurants (such as steak, seafood, chicken, pasta, and so on), there are also many kinds of mutual funds to choose from at most fund organizations. Each kind has its own "flavor."

Over the past decade, some investors have decided that traditional mutual funds seem old-fashioned compared with the newer exchange-traded funds (ETFs — these are basically mutual funds which trade throughout the day like stocks) and hedge funds (professionally-managed investment pools which typically have far fewer restrictions placed on their management and operate under less regulatory scrutiny). However, this may be a case when newer isn't necessarily better.

Some of the perceived advantages of these newer vehicles can actually be harmful, especially in the hands of less-experienced investors. It's true that ETFs can be a great tool when used as part of a well-defined, disciplined investing approach (see Using Exchange Traded Funds in a Just-the-Basics Portfolio). But for many investors, traditional mutual funds still offer a great blend of function and simplicity. That's why they remain a key building block of SMI's model portfolios.