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Mutual funds and exchange-traded funds (ETFs) are ideal investment vehicles to help you carry out your investment plans. The three main advantages of the best mutual funds and ETFs are

 Diversification: Mutual funds and ETFs typically invest in dozens of securities. A truly diversified stock fund invests in stocks in different industries and different stocks within an industry. The same logic works for bond funds, too.

 Efficiency: Good money managers don’t come cheaply. However, because funds buy and sell large blocks of securities and typically manage hundreds of millions or billions of dollars, the cost of their services is spread out and quite economical for you.

 Professional oversight: Unless you have lots of money and free time on your hands, researching investments will, at best, be a part-time hobby for you. A fund manager and his or her team of analysts are devoted full time to selecting investments and monitoring them on an ongoing basis.

The best mutual funds offer a low cost, professionally managed way to diversify your investment dollars. Index funds, which are a type of mutual fund, invest to follow a specific stock or bond market index and usually have the advantage of low costs, which helps boost your returns. ETFs are generally index-like funds that trade on a stock exchange. (See the section “Index and exchange-traded funds” later in this chapter for more details on those types of funds.)

Several different types of funds exist. Which ones work for you depends on the level of risk you desire and are able to accept. Here’s a list of the types you may choose:

 Money market funds: These funds are the safest types of mutual funds. Money market funds seek to maintain a fixed share price of $1 per share. They invest in short-term debt of companies and governments. You make your money from the dividends, just like you would with a bank savings account’s interest. The main difference and advantage that the best money market funds have over bank savings accounts are that the better ones generate a higher yield or rate of return. Because there’s little, if any, risk of bankruptcy, money funds aren’t insured the way bank accounts are.

 Bond funds: The attraction of bond funds, diversified portfolios of bonds, is that they pay higher dividends than money market funds. So, for retirees who want more current income on which to live, bond funds can make sense.The drawback or risk of bonds is that they fluctuate in value with changes in interest rates. If the overall level of interest rates rises, the market value of existing bonds decreases. This occurs because with new bonds being issued at higher interest rates, the price of existing bonds must decrease enough that the resulting yield or interest rate is comparable to that offered on new bonds. Longer-term bonds are more volatile with changes in interest rates because your principal is being repaid more years down the road.The value of bonds issued by corporations also may fluctuate with the financial fortunes of the company. When a company hits a rough patch, investors question whether their bonds will be repaid and drive the price down. When investors fear bankruptcy is a real possibility, the bonds may sell for only a fraction of the original debt or principal.

 Stock funds: Stock funds invest in shares of stock issued by companies. Most funds invest in stocks of dozens of different companies. Funds typically focus on either U.S. or international companies. Stock funds are the most volatile of mutual funds and ETFs, but they also hold the promise of higher potential returns. On average, stocks have returned investors about 9 percent per year over the decades. Over short periods, however, stocks can drop significantly in value. Drops of more than 10 or 20 percent aren’t uncommon and should be expected. So don’t commit money to stock funds that you expect to need or use within the next five years. Although they’re completely liquid on a day’s notice, you don’t want to be forced to sell a stock fund during a down period and possibly lose money.You can choose to invest in stocks by making your own selection of individual stocks or by letting a mutual fund manager do the picking and managing. Researching individual stocks can be more than a full-time job. And if you choose to take this path, remember that you’ll be competing against the pros who do it full time.

Over the years, increasing numbers of investors have turned to mutual funds and ETFs for their stock market investing rather than picking and choosing individual stocks on their own. While there’s good debate about the merits of these two investment strategies, plenty of sources are pushing investors to individual stocks. For instance, many websites, online pundits, financial columnists, and media/television gurus advocate for individual stocks. For more information on mutual funds including ETFs, check out the latest edition of Investing For Dummies, by Eric Tyson (Wiley).