Learn the lingo: Mutual Funds and Diversification

I was recently asked to do a ditty on mutual funds, or what I call the "sultry vixens" of the saving world. Why would I refer to them as sultry? Well, unlike individual stocks, which I consider "femme fatales" because of the immediate risk associated with investing in them, mutual funds are a more demure and unaggressive bird. They stand in the background and make you money without being too risky because of the diversification they bring to your life. But what is a mutual fund? And what in the heck is diversification?

Ask and you shall receive! Before your eyes glaze over with a patina of unadulterated boredom at the mere sight of the words "mutual" and "fund," you should know that a mutual fund is simply a way for you to invest your savings in an account that is operated and run by a professional investment firm or company.

Pretend you're at a casino. (Hopefully a classy Vegas joint such as the Bellagio, and not some seedy Reno dive inhabited by chain-smoking moustached men in faded trucker hats -- but this is all beside the point.) You sit at a slot machine and start funneling in your money, hoping a river of change will pour into your lap. Well, chickadees, the slot machine is like a mutual fund, and has an endless variety of ways (or investments) it can choose from to make you money. Unlike casino gambling, though, there's no random chance with mutual funds. The managers of these funds are highly skilled to invest your money in the best way possible in investments they think will give you the best returns.

These investments can include stocks, bonds, commodities (such as gold, oil, etc.), or other things depending on the fund. The essential idea is that you, the investor, can make one single investment into the fund, where it is then diversified across many different industries or investment categories by people who are well-versed in finance. If you're a newcomer to the market, you may think you should lap up just oil companies, but putting all your eggs into one basket (or one type of stock) is dangerous. Mutual funds will broaden your horizons, by making sure your money is spread evenly across the whole piece of toast, instead of just dumped on one side. Diversification is important because it protects you from the risk of losing all your money on one bad investment.

Many mutual funds are peppered with more costs than standard commission fees, but that's what you get for majoring in English versus Business, and paying Mr. Harvard-MBA to do the dirty finance work for you (or so said the brunette writing the budget blog). Kidding, kidding; I'd take English Lit. over math any day.

When I turned 18, my grandfather revealed he had set up a Vanguard mutual fund account for me (along with my brother and sister), replete with $8,000 for each of us. Although I was of age for instant access to the dough, I was told to forget it was there and treat it as a nest egg, hopefully adding to it every once in a while. Believe me, at the tender age of 18, when all I could think about was fast cars, fashion and boys, $8,000 sounded like an appealing down-payment on a BMW or an extended vacation on the shores of Baja. But I guess the seeds of frugality had already been sewn in the haunches of my late teenage years, and (heeding my parent's advice) it remained essentially untouched. Of course, that all changed in February of this year, when I got bit by the stock market fairy, pulled all of my money out of the account, and decided I could make better returns by aggressive stock trading. I highly advise you only make this kind of move, though, if you feel confident in your knowledge of the stock market or feel like you have enough time on your hands to at least learn the fundamentals (in casino speak, there is a much higher risk of the house winning in this territory).

But why am I even telling this story? Because a mutual fund, like a 401(k) or IRA, is a great way for you to set up a nest egg of your own. As much as we want to write off our parents' advice as superfluous, there's a kernel of wisdom in the "put it away and pretend it's not there" adage. The only way to accumulate is to not spend, and the only way to spend is to, in essence, "pretend it's not there." If you're lucky and never need to dip into your budding fund investment, it can even be a great thing to pass down to your future children as a seed they can continually add to and use if necessary.

So now you know what mutual funds are and why they can help in your quest for an early, lavish retirement. For ideas on which ones to invest in, read this recent top 25 fund list!