By Selena Maranjian

Imagine that you have $500 to invest. But you know little about investing and are too scared to do it on your own. You have no confidence (and, knowing little, no reason to be confident). You shrug your shoulders and park your money in a bank account or CD, earning very low interest. Sigh.

But now imagine that you have 25 friends. And each of you has between $500 and $1,000 to invest. Your grand total of dollars is $20,000. Let's say that one of you knows someone -- let's call him Cartman -- who knows all about stocks and investing. You could all decide to hand your money over to Cartman and have him invest it for you. Why would he agree to such a thing? Well, because you'll pay him to do so.

So Cartman takes a percentage of your money and invests the rest of it, deciding when to buy and sell shares of this and that. If he's good at what he does, then your investment increases in value over time. If not, then you lose money. It's a reasonable solution, no?

That's pretty much all a mutual fund is. Instead of 25 people, most funds have thousands (or tens of thousands) of investors. Instead of $20,000, the typical fund is worth millions or billions of dollars. While the average investor who invests on her own might hold stock in just eight to 15 companies, the typical mutual fund will hold shares in more than 100 companies -- often several hundred.

Kinds of Mutual Funds

Once you start looking at mutual funds, you'll discover that there are many different kinds. Here's a list of some of the main types. (Some funds fall in more than one of these categories.)

• Equity funds: "Equity" is just a fancy way of saying "stock." Equity funds are ones that invest in stocks.
• Fixed-income funds: These funds generally invest in bonds.
• Money market funds: A money market fund buys CDs and bonds issued by the government or companies. It sticks to short-term, high-quality securities and is relatively safe.

You'll typically earn less money with money market funds than bond funds, and less with bond funds than stock funds. Here are some more kinds of mutual funds -- most stock funds fall into one or more of the following categories:

• Income funds: Managers of these funds aim to generate regular payoffs for shareholders through dividends from stocks and/or bond interest. In other words, its investors should expect some regular checks from these funds. These funds are often favored by older investors such as retirees, who need an income from their investments. They're not usually the best bet for teens, as they tend to focus on companies are fairly stable but don't grow too quickly.
• Growth funds: Growth fund managers don't try to generate income. Instead, they seek stocks whose prices they expect will grow considerably.
• Value funds: These funds' managers also seek stocks they expect to grow in value, but they pay more attention to a stock's price, looking for beaten-down stocks, or ones whose prices are considerably lower than the managers think they should be.
• Balanced funds: These funds are invested in both stocks and bonds.
• Sector funds: These are invested primarily in companies in a particular industry or sector, such as restaurants, real estate, telecommunications, banking, and biotechnology. They're handy if you want to be invested in a certain industry but don't want to choose which companies in which to invest.
• Regional funds: These funds are invested primarily or exclusively in particular parts of the world. One might invest in Indian companies, another might specialize in Russian firms, and a third might limit itself to Latin American enterprises.
• Large-cap, medium-cap, and small-cap funds: These funds focus on certain sizes of companies. So a small-cap fund will buy stock in tiny companies, while a large-cap fund will invest in firms such as Ford or American Express.

There are even more categories of funds. Some, for example, are "focused," aiming to hold stock in relatively few companies, instead of hundreds. Others refer to themselves as "socially responsible," avoiding, for example, tobacco companies or firms with poor environmental records. (This is much easier said than done, though, as you can probably find something socially objectionable in almost any company.)

If all these kinds of funds have your head spinning, relax. There's one kind of fund that's The Motley Fool's favorite. We'll get to it soon. (Is the suspense killing you?)

Problems With Most Mutual Funds

Mutual funds do have their advantages. They're certainly convenient -- especially if you don't know much about investing. They give you instant diversification. It would be risky to have all your money invested in just one or two companies, but with mutual funds, you're usually in more than 100 companies (or other investments) at once. There are some considerable disadvantages, though. For example:

• Most mutual funds underperform the market average. In most time periods, more than 75% of stock mutual funds do worse than the overall stock market.
• Many mutual funds are just too big to do really well. A bunch have more than $10 billion invested in them. Imagine being the chief manager of one such fund. Maybe you've found 10 amazing companies that you'd like to put most of your money in. That means you'll have to invest around $1 billion in each. Many companies aren't that big -- you can't spend $1 billion on a $500 million company. The bigger the fund, the harder it will be to find enough promising investments and to do really well. This is part of the reason why funds are often invested in hundreds of companies.
• Most mutual funds are too diversified to do well. Imagine managing a mutual fund where you're invested (in roughly equal amounts) in 100 companies. Let's say that one or two -- or even five -- of them do really, really well. Their stock prices quadruple. This should make your mutual fund's value skyrocket, right? Well, no. Those are just a few of your holdings. Whatever they do is a drop in the bucket. A little diversification is good -- without it, you're taking on a lot of risk. If you own stock in just three companies and one really crashes, so will your overall portfolio's value. If you own stock in 10 companies, one crashing won't be a major disaster. And one skyrocketing will have a noticeable effect. But the more you add to the mix, the more diluted the effect of any one company.
• Most mutual funds charge significant fees that hurt performance. Many funds have "loads," which are sales charges. If you put $1,000 into a fund with a 5% front-end load, that means the fund company will take out $50 from the beginning, and you'll only be investing $950. (This is why many people look for "no-load" funds, of which there are many.) Beyond loads, most funds charge certain fees every year -- to pay for things such as salaries, administration, and advertising. Imagine that the stock market rose 8% one year, and your fund gained 8%, too. Pretty good, right? Well, no, not if it charges a total of 2% in annual fees. Then your return is really 6%.
• Most funds do too much buying and selling. This is called turnover, or "churning." It's bad because each time you (or a mutual fund) buys or sells something, a commission is charged. Those add up. If you have an account with a brokerage, and you pay $10 every time you trade, if you bought or sold stocks 100 times during the year, that would amount to $1,000. Yikes! The same effect can hurt a fund's profitability. In addition, if the fund is selling stocks on which it has earned a profit, then there are "capital gains," which get taxed. (Guess who pays those taxes? That's right -- you, the shareholder.)

The Solution? Try Index Funds

You can avoid most of the problems tied to mutual funds by investing in a particular kind of fund: index funds. An index fund invests automatically in all the companies that make up a particular index, such as the S&P 500. The Motley Fool recommends suggests index funds for just about anyone. Why? Here are some reasons.

• While the vast majority of mutual funds do worse than average, index funds do... average. All things considered, that's pretty good.
• While mutual funds will typically charge you 1.00% or more per year, index funds usually sport extremely low fees -- sometimes just 0.16% (that's less than a sixth of 1%).
• There's little turnover within index funds. They just hold stock in whatever companies are in the index they mirror.
• They're simple. Investing in index funds will take very little of your time or mental energy. Once you've invested in them, you can forget about them (ideally adding money periodically, though).

Index investing may not be as exciting as picking your own stocks and watching them go up (and down), but it will get the job done for you. A thousand dollars invested in a stock market index fund that earns 11% on average per year will grow to $13,585 in 25 years and to $184,565 in 50 years - just from a single initial $1,000 deposit. A mere $500 invested every year will grow to $8,400 in 10 years, $57,200 in 25 years and more than $830,000 in 50 years. (Of course, remember that over the years that you invest, your average annual return might be 9% or 13% -- or something else.)

Kinds of Indexes

There are many different indexes that track different groups of companies, and there are index funds that track each of them. The three most famous indexes are:

• The S&P 500: This is an index of 500 companies that are among of the biggest and best companies in America. Just about any major company you can think of is in the S&P 500. (Examples: Ford, Motorola, Dell, Apple, Microsoft, Intel, Cisco, eBay, Jostens, Hershey, Black & Decker, Maytag, Hasbro, Marriott, Deere, Chevron, Mead, Gillette, Wendy's, McDonald's, Coca-Cola, McGraw-Hill, The New York Times, CVS, Radio Shack, Wal-Mart, Safeway, Kroger, Staples, Toys R Us, Sprint, Fruit of the Loom, Merrill Lynch... you get the idea.) The S&P 500 is often used as a benchmark for the entire stock market. In other words, if the S&P 500 rises 5%, people will refer to the market as having risen 5%.
• The Wilshire 5000: This index is an even better benchmark for the entire stock market because it actually contains just about every U.S. stock, big and small. At one time there were 5,000 such companies, which is how it got its name. Today the index contains more than 6,500 companies -- despite its name. This is often referred to as the "total market" index.
• The Dow Jones Industrial Average: This is an index of 30 of America's biggest companies, such as General Electric, Wal-Mart, McDonald's, Coca-Cola, and Microsoft. This is the most famous index, often referred to as "The Dow." It's also the oldest index, more than 100 years old.

Why do these indexes exist? Well, they make it easy for people to get a feel for how a group of companies is doing, without having to do lots of calculations each time. There are more indexes than the ones I've listed, and for each major index, you'll find one or more mutual funds that mimic it. Each one owns shares in the very same companies as the index it follows. If you buy a few shares of an S&P 500 index fund, you instantly own a tiny chunk of each of its 500 companies.

Owning shares of index funds based on indexes such as the S&P 500 and the Wilshire 5000 is, in many ways, like owning a piece of America. If you have faith that over the next 10, 20, or 30 years America's businesses will flourish, then consider investing in an index fund.

If you want to do better than average and earn more than you would investing in the overall stock market, then you need to learn about investing in individual stocks. That means more work, but it can also mean more fun, more satisfaction, and more growth of your money. You can stop with index funds, though, and do very well -- better than most Americans.

Learn More

This article is adapted from our book, The Motley Fool Investment Guide for Teens: 8 Steps to Having More Money Than Your Parents Ever Dreamed Of . To learn more about mutual funds, index funds, and investing in stocks, check it out. Another good source of information is our mutual fund area .