Mutual funds are merely a diversified portfolio of managed funds. Instead of having to invest a huge sum of money, you chip into a pool of funds with thousands of other people. These funds are then managed by a single company, so even if one investment flops others will suceed and you are guaranteed your funds back.

1. What is the advantage of a diversified portfolio?

Diversity is good because you will have a greater chance of sucess. With diversity, we have protection against rapid market losses of any one particular stock. If a portfolio is spread across 20 stocks, if any one of those stocks quickly loses value the effect is less than if the portfolio consisted of that one stock by itself.

2. Don't put all your eggs in one basket

When investing it is always a good idea to diversify. The problem for small investors is that they often dont have the funds to buy a variety of stocks. Mutual funds allow small investors to benefit from diversification with a small amount of money.

Besides stocks, mutual funds can be made up of a variety of holdings including bonds and money market instruments. A mutual fund is actually a company and investors that buy into a fund are buying shares of that company. Shares in a mutual fund are bought directly from the fund itself or brokers acting on behalf of the fund. Shares can be redeemed by selling them back to the fund.

Some funds are managed by investment professionals who decide that securities to include in the fund. Non-managed funds are also available. They are usually based on an index such as the Dow Jones Industrial Average. The fund simply duplicates the holdings of the index it is based on so that if the Dow Jones (for example) rises by 5% the mutual fund based on that index also rises by the same amount. Non-managed funds often perform very well sometimes better than managed funds.

There are downsides to mutual funds. There are usually fees that must be paid no matter how the fund performs, and the individual investor has no say in that securities can be included in the fund. Also, the actual value of a mutual fund share is not known with the same precision as stocks on the stock market.

Mutual funds are often a better choice for the small investor than either stocks or bonds. They offer the diversity that provides cushion against sudden stock market movements and usually provide a greater return than bonds. Of course, mutual funds can also lose value, especially in the short term, so short term investors may be better off with bonds that offer a set rate of return.

There are three main types of mutual funds: money market funds, bond funds and stock funds. Money market funds offer the lowest risk they consist solely of high quality investments such as those issued by the US government and blue chip corporations. Money market funds have rarely lost money, but they pay a low rate of return.

Bond funds aim to produce higher yields than money market funds and therefore carry a correspondingly higher risk. All the risks that are associated with bonds company bankruptcy, falling interest rates also apply to bond funds.

It should be known, however, that stocks still have the greatest potential for profit. The risk is more for short-term holders of mutual funds stocks have traditionally outperformed other investment instruments in the long run. Of course, with this added potential also comes greater levels of risk.