Mutual funds can be an excellent way to invest in the stock market, especially for new investors. They don't require a great deal of expertise to understand or evaluate, and can allow the average American to match, or potentially beat the market's performance. If you're new to mutual fund investing, here's a rundown of what you should know before you get started.

What is a mutual fund?

A mutual fund is a way to invest in things like stocks and bonds, but without the research and risk involved with choosing individual investments.

Mutual fund section of a newspaper.

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With a mutual fund, your money is pooled with money from other investors and is then managed professionally, for a fee. Not only does this mean that you'll have a trained professional researching and selecting stocks and bonds for you, but it also means you'll get an investment portfolio that's far more diversified than you'd likely be able to construct by yourself.

In other words, while the typical stock investor might have a dozen stocks in his or her portfolio, a mutual fund may spread investors' money among hundreds of different stocks.

You can invest in mutual funds directly through the companies that offer them, such as Vanguard, T. Rowe Price, and Fidelity. Or, you can invest in many mutual funds through your online brokerage account as well. It's also important to point out that if you have a 401(k) or similar retirement plan at work, the investment options offered by your plan are different types of mutual funds as well.

You can find mutual funds that invest in stocks, bonds, as well as other types of investments, such as commodities. Within each category, there are a variety of sub-types, such as growth stocks and value stocks, and a variety of risk levels. In a nutshell, there are mutual funds that are appropriate for everyone to create a properly allocated investment portfolio.

Why invest in mutual funds?

Essentially, mutual funds can be excellent options for investors who don't have the time, knowledge, or desire to research individual stocks and bonds on their own. If you have all three of those things, researching and investing in individual stocks can be a smart idea, but if not, you may be better off investing in funds.

In addition, mutual funds can be a smart way for any investor to add diversification to a portfolio. For example, new investors often cannot afford to buy enough individual stocks to properly diversify a portfolio, so an alternative approach would be to buy shares of a diversified mutual fund to establish a "base," and one or two individual stocks to get started.

The two main types of mutual funds

There are thousands of mutual funds available, and all can be classified into one of two broad categories -- actively managed or passively managed funds.

Actively managed mutual funds employ fund managers whose job it is to invest the fund's assets. These managers research and select individual investments and choose when to buy and sell them. In a nutshell, an actively managed fund's goal is to beat the market. Because the managers need to be paid, actively managed mutual funds typically have higher costs, which we'll get to in the next section.

On the other hand, passively managed mutual funds simply track a certain index, such as the S&P 500. For this reason, these are also known as index funds. Because the managers of passively managed mutual funds don't have to spend much time investing the fund's assets, the expenses associated with these funds tend to be relatively low.

Costs of mutual fund investing

There are a few costs you may have to pay when investing in a particular mutual fund.

First, all mutual funds have an expense ratio, which is the fund's annual operating expenses as a percentage of its assets. The expense ratio includes fees paid to the fund's managers, as well as any administrative costs of running the fund. As an example, an expense ratio of 0.5% means that for every $10,000 you have invested, you'll pay $50 in fees each year.

To complicate matters, you may see two types of expense ratio listed -- gross and net. The net expense ratio is the cost investors are actually paying and may include things like temporary discounts. On the other hand, the gross expense ratio is the non-discounted, or standard expense ratio. This is why the net expense ratio is often lower, but it's important to pay attention to the gross expense ratio, as it represents what you could end up paying in the future.

Another type of expense is a sales charge, or load, which you may or may not have to pay. Simply put, this is a commission that is paid to financial planners, brokers, or investment advisors, and can be paid upfront when you invest (a front-end sales charge) or when you eventually sell your shares of the fund (a back-end sales charge). Many investors will only look at no-load mutual funds, and most online brokerages make it fairly easy to filter out the funds with sales charges.

What the mutual fund "ratings" mean

When you're comparing mutual funds, you may notice that there are "ratings" listed in the descriptions of certain funds. Two common mutual fund rating systems are the Morningstar and Lipper ratings, so here's a quick explanation of how each one works.

Morningstar rates funds on a scale of one-to-five stars, with five being the highest possible rating. The system calculates different ratings for different time periods, such as three-, five- and 10-years, and considers factors such as the fund's past performance, risk-adjusted returns, and more. Here's how Morningstar assigns ratings:

  • The top 10% of evaluated funds get five stars
  • The next 22.5% get four stars
  • The middle 35% get three stars
  • The 22.5% below this group get two stars
  • The bottom 10% get one star

The Lipper rating system works a little differently. It uses five criteria – consistency, preservation of capital, expense ratios, total return, and tax efficiency. Like Morningstar, Lipper also has five ratings, but it's a simpler classification system -- 20% of funds in a given category get the top rating, 20% get the next highest, etc.

Ratings are certainly important to look at, but take them with a grain of salt. Mutual fund ratings are based on past performance, not future expectations. And all beginning investors should know that an investment's past performance is not a guarantee of future results.

The bottom line on mutual funds

Mutual funds can be an excellent investment choice for many Americans, especially low-cost index funds, which Warren Buffett has referred to as the best investment that most people can make. The smartest thing you can do before you get started is to learn the basics of how mutual funds work and how to compare the costs and objectives of different types of funds.

The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.