Before you learn what a mutual fund is, you need to understand what stocks and bonds are. When you buy a stock, you are one of countless owners of that company. As an owner, you may get to share in some of the profits of the company. When you buy a bond you are a creditor to the organization. You are lending money and they agree to pay it back to you at interest.

When you create your own investment portfolio you must know how to best allocate the funds based on your risk tolerance, the time you have until you need the money, and your financial situation. You must determine how many large-cap international growth stocks to own and how many mid-cap domestic bonds to have, as an example.

Now that we have the basics out of the way, what are mutual funds?

Most people don't have the time or knowledge to build appropriate, diversified, risk managed portfolios for themselves. The also don't usually have the skills or interest to rebalance or realign their portfolios as individual companies changes. This is where mutual funds come in.

A mutual fund picks the individual investments based upon the goals of that fund. All you have to do is invest in the mutual fund and you are automatically diversified into all the investments that the fund managers have selected for the fund. This makes investing simple for most people. However, for this convenience, there is usually sales, management, and advertising fees. The smart people who pick the winners have to get paid somehow, right?

Each mutual fund has its own objective. When you have enough assets, then it is appropriate to diversify even further in order to reduce your risk even more. This is when you develop a portfolio of mutual funds and have your money allocated among them according to your risk tolerance.

Overall, investing in individual stocks or bonds has much more risk than investing in mutual fund. Mutual funds are appropriate for the majority of people and they help to reduce risk while making decisions simpler for everyday investors.