Question: What are the advantages of investing in mutual funds vs. individual stocks?

Mutual funds can offer instant diversification, and diversification reduces risk. Funds can reduce risk by spreading it among a large number of investments. By holding lots of securities, if one stock performs badly, its impact on the overall portfolio can be mitigated. Funds can also reduce risk by investing in a number of different asset classes: stocks (which can include international as well as U.S. stocks), bonds, cash and other securities. Individual investors who desire to achieve the same level of diversification might have to own -- as well as understand and track -- more investments than would be manageable.

Many mutual funds can be purchased commission free, which reduces the impact of commissions and expenses on an investor's portfolio. Also, by pooling money accepted from many investors, mutual funds can reduce the percentage that expenses eat up in a portfolio. Many investors strive to keep commissions as low as possible, but they can still swallow 3-5% of an investor's portfolio. Funds typically have expenses of about 1-2%. Of course, if a fund is bought through a broker who charges a commission, or if the fund charges a load, then these savings may be lost.

Funds provide ways of targeting sectors and specific goals. An example: international funds offer a way of investing globally without worrying about currency or political risks. Fund companies hire experts who understand the complicated capital markets outside the United States, and can follow and react to news in those markets faster than most individuals. Fixed-income and tax-free mutual funds also fulfill very distinct purposes. Likewise, an index fund can ensure that an investor matches the performance of the overall market (or sector) year after year.

Mutual funds are a very liquid investment for individuals. If cash is needed in a hurry, an investor can always sell fund shares and get that day's closing redemption price. There is no need to worry about finding a buyer or at what price the shares might sell.

Mutual fund companies often offer an array of attractive free services for shareholders: reinvestment of dividends and distributions, the ability to transfer between funds in a family, systematic investment or withdrawal plans to allow you to invest or sell on a monthly basis, detailed recordkeeping and tax reports.

Question: What are the potential disadvantages of investing in mutual funds?

This is probably the biggest reason not to invest in mutual funds: each year, something like 80% of all mutual funds perform worse than average. And these are paid professionals!

One of the reasons for these dismal returns is that funds have a variety of fees and expenses. All funds have fees for management and operating expenses, which typically range from 1-2%.

But some funds also charge a sales fee (known as a "load") of 3-5% and in some cases up to 8 1/2%. Finally, there are funds which charge "distribution fees" or "12b-1 fees" to their investors. There are marketing and advertising costs which are passed right along to the fundholders. Obviously, these expenses can severely impact an investor's return and must be carefully considered (and usually avoided).

Large funds are so big that it's hard for them to find investments that provide enough liquidity. Fidelity's Magellan fund has assets of $51.6 billion dollars, larger than the market caps of Colgate-Palmolive, JC Penney, H.J. Heinz and Caterpillar -- combined. Magellan has to take a very large position in the stocks it holds in order to provide an adequate return, which reduces its universe of potential investments.

To be prepared for withdrawals (and provide for the liquidity that investors seek), funds typically have to maintain a large cash position. This is money that's not working to best advantage for the investors.

Another disadvantage of mutual funds is that it's nearly impossible to tell if the fund is a good value at any particular point in time. Unlike stocks, where it is possible to tell if a stock is undervalued according to any of several different measures, it is much harder to determine if a mutual fund's Net Asset Value represents a good value or not. A fund could have shown a solid rate of return for a particular period, but that could be a result of its holdings having reached peaks from which they might then plateau or decline.

A fund is only as good as its management. And fund managers can change. The Magellan Fund survived Peter Lynch's departure, but other funds have not done so well when a dynamic and talented manager has left. There are some exceptions, such as funds in the Twentieth Century family, which have no individual manager but are guided by committee.

"Past performance is no indication of future results." This disclaimer should serve as a reminder that last year's hot fund may be this year's big loser. An informed investor needs to be aware of the drawbacks and advantages of mutual funds -- the investor who has clear investing goals and who does his or her homework will inevitably succeed. Finding a winning fund takes care: Read the prospectus. Examine the fund's holdings. Understand the fund manager's style and the fund's strategy. Ensure that the fund's style and strategy fits the investor's goals. These are the first steps towards successful fund investing.