Introduction

There's an endless array of mutual funds out there, and each one would like you to think that it's got just the right combination of features to tempt your taste for investment. But to make things simpler, you might begin by thinking about mutual funds in three main cateogries:

They are:

stock funds, also known as equity funds

bond funds

money market funds

Each individual fund fits into one of those categories, or is a blend of two of them. And naturally, each basic type has a number of subtypes, each with a specific investment goal.

Diversification

Because individual mutual funds are actually a collection of many different investment products, funds are sometimes referred to as a "diversified" investment.

The point of diversifying, or owning a variety of different stocks or bonds, is that what you may lose on some of them will almost always be offset - or overshadowed - by gains in others. The down side, of course, is that the profit from the winning components of your portfolio can be dragged down by the losers.

For most individual investors, the major advantage in buying a fund (instead of putting money into individual stocks or bonds), is the greater diversification you get for the same amount of money.

Stock Funds

Stock funds buy and sell shares of stock being traded on exchanges in the US and around the world.

Stock fund portfolios vary, depending on the fund's specific investment objectives. For example:

Income funds invest in well-established companies - known as blue chip companies - that pay regular dividends.

Growth funds invest in young, promising firms, or companies that have been operating below expectation for several years.

Sector funds buy shares of various companies doing the same kind of business.

Like individual investors, funds buy stocks they expect to perform well, and try to keep a balance in their portfolios. For example, they may buy cyclical stocks, whose performance is tied to changes in the economy, to take advantage of boom times. Or they may buy value stocks, which are cheap now but should be worth more in the future.

Making Money with Stock Funds

What you make on a stock fund depends on two things:

The value of the investments in its portfolio, and

whether or nor they pay "dividends."

If the value of the fund's shares, called its net asset value, or NAV, increases and you can sell your shares for more than you paid for them, you make money. (Of course, a NAV can also drop, in which case your investment would be worth less.)

Plus, if the fund itself makes money, you get your share of the profits as dividends, or distributions. If you reinvest your earnings, the value of your investment increases regularly, giving you a bigger base on which to earn the next round of dividends.

Bond Funds

A bond fund is simply a mutual fund that invests in different bonds.

The goal of a bond fund is to provide investors with regular income. That makes it different from, say, certain stock funds that aim to give you a bigger payoff at the end of a longer-term investment, instead of regular returns.

Even though all bond funds are designed to generate an income, the ways they go about it vary widely.

You can buy a fund investing in grade corporate bonds or one buying riskier junk bonds (often sold under the promising label of "high yield" funds). You can choose a fund that will invest in either long- or short-term US Treasury bond funds, or in a variety of tax-exempt municipal bond funds (including some that, under certain cirumstances, can save you state taxes).

Buying into a bond fund can require a lot less money than buying individual bonds on your own - and you get a diversified portfolio to boot. For example, many bonds sell for $5,000 or more, but you can often invest in a fund for $1,000 and make additional purchases for even smaller amounts.

Making Money with Bond Funds

There are two ways to make money on a bond fund:
You can earn a profit from the interest the bonds pay.
And you can earn money if the fund's price-per-share increases and you sell the bond at a profit.

You can also sell your shares in a bond fund at any time to benefit from an increase in price.

Bonds purchased individually will have a maturity date; after that date you receive a guaranteed minimum price by cashing in that bond.

Bond funds, on the other hand, have no maturity date and do not guarantee that you will get back the amount you invest. If the value of the fund decreases, and you have to sell, you could get less back than you put in.

Money Market Funds

A money market fund is a lot like a bank account that combines both checking and savings.

With a money market fund, you are guaranteed to get back every dollar you pay in. Plus, it pays regular interest, just like a bank account. And since the value of each share remains set at one dollar, you don't have to figure profit or loss when you redeem (or sell) your shares.

As an added appeal, most money market funds let investors write checks against their accounts. There's usually no charge for check-writing, although there may be a per-check minimum--usually between $250 and $500.

Making Money with Money Market Funds

As with many investments, money market funds represent a tradeoff. Less risk, but less potential for profit too.

Your money is usually safe in a money market fund, but it's not growing as fast as it could in other investments.

Money market funds are essentially risk free, although they're not insured by the FDIC the way most standard commercial bank accounts are.

Many investors choose money markets over stock or bond funds because of this added safety. But the interest the funds pay is low when interest rates are low and is rarely much more than the rate of inflation. That means the value of the money fund can actually shrink in the long run, since the money you keep in it will buy less and less if inflation rises.

But while a money fund isn't really an investment, it's a handy place to keep your cash reserve or money you're planning to invest.

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