As you probably know, mutual funds have become extremely popular over the last 20 years. What was once just another obscure financial instrument is now a part of our daily lives. More than 80 million people, or one half of the households in America, invest in mutual funds. That means that, in the United States alone, trillions (yes, with a "T") of dollars are invested in mutual funds.

In fact, to many people, investing means buying mutual funds. After all, it's common knowledge that investing in mutual funds is (or at least should be) better than simply letting your cash waste away in a savings account, but, for most people, that's where the understanding of funds ends. It doesn't help that mutual fund salespeople speak a strange language that, sounding sort of like English, is interspersed with jargon like MER, NAVPS, load/no-load, etc.

A mutual fund is nothing more than a collection of stocks and/or bonds. You can think of a mutual fund as a company that brings together a group of people and invests their money in stocks, bonds, and other securities. Each investor owns shares, which represent a portion of the holdings of the fund.

12b-1 Fee
Promotion expenses such as advertising and public relations that are paid for by shareholders

Account minimum
The minimum amount a Fool must initially invest in a fund, typically between $1,000 and $10,000.

Administrative costs
Costs of record keeping, mailings, maintaining a customer service line, etc. These are all necessary costs, though they vary in size from fund to fund. The thriftiest funds can keep these costs below 0.20% of fund assets, while the ones who use engraved paper, colorful graphics, and phone answers with highfalutin' accents might fail to keep administrative costs below 0.40% of fund assets.

Average cost
One of three methods to determine the cost basis of the mutual fund shares you sell. Under this method, you determine the average price of all your shares, including those purchased with reinvested dividends and capital gains. That price becomes your cost basis. In the How-To Pick the Best Mutual Fund Guide, we practice calculating the cost basis for your fund.

Back-end load
Funds with back-end loads are sometimes called "B" shares. These funds impose a contingent deferred sales charge, or CDSC, which is paid at the time of redemption. This fee is generally much higher than a front-end load. The good news is that it declines incrementally to zero over time, and usually disappears in five to eight years. These funds charge 12b-1 fees, which are typically higher than for front-end load funds. These funds may convert "B" shares into "A" shares after the load period has expired.

Blended fund
These mutual funds are generally a combination of growth and value stocks.

Bond index funds
In the world of bond investing, we don't see any reason to go anywhere but a bond index fund. The top dog is the Vanguard Total Bond Market Fund (VBMFX), which mimics the Lehman Brothers Aggregate Bond Index. There are also short-, intermediate-, and long-term bond funds.

Originally mutual funds were heralded as a way for the little guy to get a piece of the market. Instead of spending all your free time buried in the financial pages of the Wall Street Journal, all you have to do is buy a mutual fund and you'd be set on your way to financial freedom. As you might have guessed, it's not that easy. Mutual funds are an excellent idea in theory, but, in reality, they haven't always delivered. Not all mutual funds are created equal, and investing in mutuals isn't as easy as throwing your money at the first salesperson who solicits your business.

This is why we've written this tutorial. We'll explain the basics of mutual funds and hopefully clear up some of the myths around them. You can then decide whether or not they are right for you.

No matter what type of investor you are there is bound to be a mutual fund that fits your style. According to the last count there are over 10,000 mutual funds in North America! That means there are more mutual funds than stocks.

It's important to understand that each mutual fund has different risks and rewards. In general, the higher the potential return, the higher the risk of loss. Although some funds are less risky than others, all funds have some level of risk--it's never possible to diversify away all risk. This is a fact for all investments. (You can learn more about this in our financial concepts tutorial.)

Each fund has a predetermined investment objective that tailors the fund's assets, regions of investments, and investment strategies. At the fundamental level, there are three varieties of mutual funds:
1) Equity funds (stocks)
2) Fixed-income funds (bonds)
3) Money market funds

Capital gains
When the fund sells a stock, it incurs short-term and long-term capital gains or losses. Unlike a corporation, a mutual fund does not itself pay income taxes. By law, each year the fund must distribute that year's net investment income (the total of dividends and interest received less fund expenses) and net realized gain (gains less losses on securities sales) to the fund's shareholders. That means that you get to foot the taxes due on those gainsFor various reasons, actively managed mutual funds don't invest all the money at their disposal, but instead maintain cash balances of approximately 8%.

Disclosure of mutual fund after-tax returns
SEC rule requiring all mutual funds to state explicitly their after-tax returns in their prospectuses, starting February 15, 2002.

All mutual funds are variations of these three asset classes. For example, while equity funds that invest in fast-growing companies are known as growth funds, equity funds that invest only in companies of the same sector or region are known as specialty funds.

Let's go over the many different flavors of funds. We'll start with the safest and then work through to the more risky.

The money market consists of short-term debt instruments, mostly T-bills. This is a safe place to park your money. You won't get great returns, but you won't have to worry about losing your principal. A typical return is twice the amount you would earn in a regular checking/savings account and a little less than the average certificate of deposit (CD). We've got a whole tutorial on the money market if you'd like to learn more about it.