Mutual funds are when groups of people pool their money together and invest it collectively. There are many mutual fund companies in the United States, with Fidelity and Vanguard being the most notable. The primary reason for investing in mutual funds is to diversify. Diversification simply means to NOT PUT all of your eggs in one basket. A mutual fund may own stock in 200 companies, so if one of the companies drops in price significantly, there are 199 other companies that are hopefully going up or not dropping significantly.
Mutual funds generally do not trade like stocks. They price at a Net Asset Value determined at the end of the trading day, which represents the value of all the stocks or bonds a fund may own. Today there are also ETFs, or Exchange Traded Funds, which fluctuate in price throughout the day and can be bought or sold like stocks.
Buying index funds is a popular way to diversify. The Standard & Poor's 500 Index is a "basket" of 500 companies in the U.S. economy. On average, hopefully, more stocks go up in this basket than go down, meaning the entire market is generally rising. The S&P 500 may gain or lose only 7% in an entire year, while a single stock may go up or down by 50% in one year. Index fund ownership is a method employed to reduce risk and avoid wild swings in individual stocks. There are of course years when the entire market goes down and not up, and investing in the stock market is a long term proposition.
Mutual Funds are available in different forms. Many funds are classified by type. During different phases of the business cycle, large stock funds might outperform small stocks, or growth stocks might outperform value stocks. Based on your Retirement Goals and age, a portfolio can be developed using a classification table of stocks. A person that is close to retirement age may have 25% of their money in the stock market, and put it in a Large Cap Value Fund which has less risk and higher dividends. A young person may have 65% of their money in the stock market, most of which in a Mid Cap Growth Fund.
Also remember it is very important that you diversify your mutual fund purchases, just like if buying the stocks & bonds yourself. An example portfolio at age 30 might be 35% in bond funds (a short term fund and intermediate fund), and 65% in stock funds (a growth fund, index fund, and maybe an international fund). A Certified Financial Planner (CFP) can help you make these investment decisions.
There are many, many different kinds of mutual funds, from emerging markets by individual country, or by specific industry such as large consumer cyclical. A new investor should educate him or herself before thinking about buying specialized funds.
It is very important to evaluate your long term retirement plan. If you are too conservative when you are young, you may have to work for many years more than expected (have low returns, and not grow the total fast enough). If you are too aggressive when you are nearing retirement, you may also end up working for many more years than you thought (lose a lot and not have time to gain it back).
From a historical perspective, the first mutual fund in the United States was established in Boston in 1924, the Massachusetts Investors Trust company.
Professional advice from a Certified Financial Planner (CFP) should always be sought before making any important investing decisions.