Mutual funds are investments that can give you instant portfolio diversification. (Portfolio is the term given to all your investments.) As I mentioned in my earlier hubs, they the benefit of diversification is not without cost. The more stock you hold, the less risk you have, but you will often fall short of the return you can make by investing in fewer, well-chosen companies or a low turnover index fund. Some estimates have that shortfall at about 2%.

The fees charged by mutual funds managers plus the fact they turn over stock quite rapidly (sometimes 100% a year) lends itself to a high capital gains costs. This can have sizable impact on you at tax time depending, of course on your tax bracket.

With that quickie recap, let’s move on to the fun stuff. Let’s say you’ve got $1000 just itching to go to work for you. You’ve decided to put it into a mutual fund so you go shopping only to discover a staggering number of options. How can you choose which fund would be the best. Start by breaking the decision making process down into bite sized pieces.

First, decide if you want to invest in equity funds, debt funds, mixed, or index funds. A word of advice, index funds have proven to yield better returns than other types of mutual funds. This is primarily because the maintenance costs are low as is the turnover. Hmmm, what do you do? It’s a good idea to understand the difference between these various funds.

Equity funds - These are funds that invest in a variety of public traded large or small cap companies either from the U.S., a single other country, or a variety of countries.

Debt funds - Debt funds invest in debt securities such as the bond market.

Mixed funds - These funds invest in both equity and debt funds. They vary the weight of their holdings depending on the market.

Index funds - Index funds invest in a market index. The various indexes include the Standard and Poor’s 500, Nasdaq-100, and others. These are passively managed funds and as such can have significantly lower costs to you, the investor. (A passively managed investment strategy is where there is a minimum of buying and selling thus minimizing transaction costs and capital gains tax.) If you want to know more about the various indexes, you can visit theStreet Authority website. It lists them and explains what each represents.

I personally don’t invest in mutual funds; I prefer exchange traded funds (ETFs) which I’ll be covering in another hub. If I were contributing a small amount each month to a fund, I would still invest in ETFs, but I’d do it with a no fee account. If I didn’t, the transaction fees would chew too deeply into my profits and I hate it when that happens. However, I invest in chunks and like to maintain a hold pattern, so I buy ETFs free from worry over transaction fees.

If I did put my money in index funds, which I don’t, I would probably divide my investment between the S&P 500 and NASDAQ 100 about 50/50 and find a good no-load fund. That’s me. You have to make your own decisions based on your specific investment strategy, which should be based on the money you have available to invest, your specific financial needs and goals, and your fear factor. (I have a low fear factor because I am well diversified and have a good money manager.)