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Mutual Funds for Beginners

Compared with investing in individual stocks, mutual funds represent a relatively simple investment solution. If you don't have to time to pore over a company's financial reports and read the tea leaves of a prospective investment's most recent quarterly earnings conference call, funds are downright elegant.

Sure, you need to read carefully the prospectus of any fund you're considering, and I'd urge you to spend quality time with its most recent annual and semiannual reports, too. At the end of the day, though, there's a straightforward set of criteria you should apply before taking the plunge with any mutual fund.

That criteria lies at the heart of the process I use to cherry-pick winners for the Fool's Champion Funds newsletter service. The newsletter is 18 months old now and, slowly but surely, we're in the process of building a solid track record. On average, our Champs are beating the market by more than 6.5 percentage points. And they said it couldn't be done.

(For a sneak peek at the newsletter -- along with every recommendation I've made since we first opened for business -- click here for a free 30-day test-drive.)

As you might expect, I firmly believe that mutual funds represent the ideal savings vehicle for serious long-term investors. But that said, there's no denying that, like every other investment vehicle under the sun, mutual funds have lots of moving parts. Below, I begin explaining how some of the most important of them work together.

NAV stands for net asset value, and it's the price you'll pay to purchase a share of a fund. Beyond that, though, NAV has precious little in common with a stock's price. That's because, unlike with stocks, there's no supply-demand dynamic that directly drives a fund's price. Instead, NAV simply represents the total value of the fund's assets -- and that would include any cash or cash equivalents that it holds -- divided by the number of shares in circulation and adjusted for fees. What's more, so long as a fund remains open to new money, additional shares are always available to first-timers and current investors alike.

Rather than using NAV to get a bead on a fund's relative valuations, then, you need to look under the hood at its underlying holdings. Services such as Yahoo! (Nasdaq: YHOO  ) Finance and Morningstar provide average portfolio metrics -- such measures as price to earnings, price to cash flow, and price to book value, for example -- and, while these ratios will change as the fund's portfolio does, examining them can go a long way toward helping you understand the investment "style" of the fund.

Speaking of which ...

Style refers to where a fund falls on the market-cap and growth/valuation spectrums, and it's the concept that gives us such mutual fund beasts as "large growth" (which sounds like a debilitating ailment) and "small growth" (which, at a glance anyway, doesn't sound like a very compelling investment proposition).

All kidding aside, when Chicago-based research house Morningstar unveiled its famous "style box" in 1992, the company (for whom I used to work) did investors a tremendous favor: At long last, it was possible to group like-minded funds together, compare them on a relative basis, and then select the cream of each category's crop toward the end of building a smartly diversified portfolio.

But as helpful as the style box is, it's really just a blunt instrument. Not all large-cap blend funds, to pick just one example, are created equal.

Yes, to be sure, these funds target an area of the market that includes the likes of General Electric (NYSE: GE  ) , Motorola (NYSE: MOT  ) , Citigroup (NYSE: C  ) , and Merck (NYSE: MRK  ) . Thing is, however, the large-blend peer group is far from monolithic. It includes, for instance, Vanguard Total Stock Market (FUND: VTSMX  ) and Vanguard 500 Index (FUND: VFINX  ) -- passively managed index funds whose portfolios hold thousands and hundreds of names, respectively. At the same time, the category also includes Neuberger Berman Socially Responsive, a fund whose portfolio of fewer than 40 names is screened to eliminate, among other things, companies that are connected to tobacco, gambling, nuclear energy, and alcohol.

The upshot, then, is this: Because such disparate funds can be lumped together in the same category, it's critical to "deconstruct" the peer groups to ensure that the comparisons you're making are of the apples-to-apples variety. If not, you could be missing out on important, market-beating opportunities.

With that in mind, as I do the research that leads to the recommendations I make in Champion Funds, I operate with a broader concept of style in mind, one that includes such factors as strategy and how volatile a fund is likely to be given the size and composition of its portfolio.

As you go shopping for funds, I'd certainly encourage you to do the same. And I'd also encourage you to pay careful attention to all of the costs associated with a fund -- not just its expense ratio. To help get you started there, the next installment of "Mutual Funds for Beginners" will cover the topic of mutual fund fees.

Stay tuned.

Shannon Zimmerman is the lead analyst for Champion Funds. He owns shares of Vanguard Total Stock Market. The Fool has a strict disclosure policy, and you can read all about ithere.

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