I remember in the early days of my seminar work — over 35 years ago — I would spend 90 minutes talking to a large room full of investors about how to "read" a stock chart. I kept it simple, to the point, and always sought to keep my listeners' attention.

But, nearly every time, after I opened the floor to questions, the topic would eventually come around to mutual funds and how to select "good" mutual funds. I remember how, after the seminar was over, I would always wonder why the questions didn't spend more time talking specific stock charts and how to read their current meaning.

Story continues below . . .

However, after 3-4 years of this seminar work, I finally recognized why mutual funds always seemed to gain the spotlight. Most investors are not professionals that spend all day, every day studying stocks histories, stock charts, stock performance, and the like. They are simply folks that wanted to make money in the stock market, but recognized they were really unable to compete with the pros. Their solution was to try and "join" the best pros. Paying the pro to do their analysis work seemed like a fair trade for having the pro tell them the best way to invest their money.

Each to his own, I guess. I really have no quarrel if one wants to pay someone to help make their investment decisions. But, it seems imperative to me that one needs to learn what makes a good stock or mutual fund investment.

Story Continues Below

A few weeks from now, I will elaborate on the more specific questions of how to ferret out and select the better income mutual funds from the huge selection of also-rans and the downright undesirable funds and how to keep tabs on portfolio manager's performance. But today, we will focus on the more simple matters of just how mutual funds are structured and what are the important features to understand. Let's begin with these two points:

Point #1. I recommend that about 25 percent of your portfolio be in mutual funds. (see my Feb. 8 article "Two Rules for Allocating Your Income Investments " for more details on this recommendation at MoneyNews.com Expert's Corner Income Investing with Max Whitmore). Some investors may want to go as high as 35 percent, but, as I said, I am of the opinion that if you begin to give all your investing decisions to the pros, you will never learn what you must to properly manage your portfolio. "Hands on" investing I call it. What you learn will prove to be a huge benefit as you draw closer to retirement.

Point #2. I have already told you, I am a believer that there is nothing wrong with incurring an expense when someone (hopefully successfully) expends their time and efforts helping you invest. But, when it comes to mutual funds, you MUST, right out of the box, be aware of the single, most damaging expense to your mutual fund portfolio, the Sales Commission. This sales charge (or "front-end" fee as it is often called) is charged by some mutual funds when you buy shares of their fund. Often, this fee can run 4-6 percent of the total investment you make and is charged the day you buy the fund shares. It is money that disappears on day one!

[Editor's Note:5 Super-Safe Cash Investments - Beat Stocks by 500%]

Now look, I was a broker over 38 years ago when just about every mutual fund charged 5-7 percent to buy their shares. Then, it was the norm. I made a good living selling funds. Still have a silver cup for being the best at it one year. But, folks, in today's environment, front end fees are just not necessary! There is a good alternative.

You may have heard the term "no-load mutual funds" before. These mutual funds charge no sales commission to buy their shares. Believe me, it is the only way to go. But even with no-load funds, you still need to be alert and careful. Investigate each and every expense charged by any fund, things like redemption or "back-end" fees, yearly management fees, and the sometimes seen "constant fee" or "level load" fee (a fee charged for each year you are in the fund.) Some funds charge no front or back-end fee, but do charge this annual or constant/level fee.

You need to understand that all of these fees can one day substantially affect the eventual bottom-line return you will receive from your mutual fund investment. Let's talk about these fees in more detail.

Sales Commission. This fee was the early and historical way that mutual funds enticed stock brokers to sell shares of their fund so the fund would have money to invest. In those days, volume on the stock exchanges was really quite low (a good day was 3-4 million shares A DAY!) and the percentage of the general public that was invested in the stock market was less than 30 percent, typically. So to survive, funds paid brokers a hefty fee to help raise money for them.

Today, however, a billion-share day is the norm and over 70 percent of the general public owns shares of stock in some form or another. The competition for investors' funds is fierce. At the same time, investors are far more savvy than in the "old" days. Today, sales efforts by funds include, mail, email, TV, word of mouth, etc. There is little need for funds to depend solely on brokers. So, many funds do sell shares with no sales commission as an enticement for investors to be part of their fund.

And let me dispel an old fable. In the early days, brokers claimed that no-load funds were poor performers (always helped to knock the competition, you know). But, time has proven that charge to be false. Many no-load funds do as well and some many times better than loaded funds. My advice — NEVER buy a loaded fund! Enough said.

Redemption Fees. This fee, often referred to as the "back-end" fee, is one that you MUST be aware of at all times. Many funds that are no-load do charge a fee if you redeem shares. They will often start at the 2-3 percent level of the amount redeemed and some go as high as 5-6 percent. Often, the fee will be based on the length of time you keep your money in the fund. If the time is short, the redemption fee will be higher. As your funds stay in longer, the redemption fee drops. Many will completely eliminate the redemption fee if you keep your investment with them long enough. Now, I have no quarrel with the redemption fee concept. The fund needs to have some stability regarding incoming and outgoing monies and the redemption fee penalty gives investors a reason to stay with the fund longer, thus achieving this stability. All I would say to you is look carefully at the fund's policy on redemption fees. Be sure the ones with the shortest period of time to arrive at a very low or no redemption fee status also is a fund that has a good investment record over time.

Management Fees. Ahhhhh, we come to the true fly in the ointment of the mutual fund business. Management fees are literally all over the lot in this business. Some charge no management fee. Others charge as much as 3 percent or more PER YEAR! How does one make an informed decision regarding management fees?

First, remember the smaller the fund, usually the higher the management fee, based on a percentage of dollars you have invested basis. That is, to cover their cost and make a profit (yes, mutual funds are there to make a profit just like any business), they must extract money from their total invested funds to do so. The only funds they have to work with are yours! So you better do your homework before you invest.

Second, always begin by looking at the fund's PROSPECTUS (more on this below) and see what its history has been regarding fees. Check carefully what their management fees are today as a percent of the total funds assets. The lower the better — EXCEPT, of course, if their performance is sub-par. In that case, just forget that fund altogether.

Performance should be the first consideration, then management fees. I would be happy to pay a 2 percent management fee (very, very high, by the way) if the mutual fund was making 20 percent on my investment over time — (after fees, of course)! Any investor in their right mind would be ecstatic with such results! Just be sure you understand the history of fees for the funds you finally select.

Constant Fees. Some funds charge what has become known as a "constant" fee. Often, such funds charge no sales commission, redemption fees, or management fees. I would advise against investing in such funds, however. This approach totally disregards the incentive to the fund managers to strive for better performance and lower management fees to satisfy (and keep) their investors. I won't go into the history behind this kind of fee, but I'll just tell you that if the fund uses this type of fee, just walk on by. Period!

The Prospectus. The prospectus of every mutual fund is a required document. It must be provided to every investor they solicit for funds. Its content is mandated by the Securities And Exchange Commission (SEC) and is diligently policed by them to assure that every mutual fund abides by the full disclosures provisions required by law. The language in most prospectuses is often boring and shadowed with legalese — UGH! But, in most of them, the real meat of the funds performance, fees, and other history (since the fund was opened, right up until now) is boiled down to about 4-5 pages somewhere in the middle of all this "gunk". I will give you more on how to read these documents in a subsequent article. But for now, remember this rule. Never invest in a mutual fund until you have looked at this document yourself — carefully! Understanding what you are getting into will save you money and aggravation later.

All funds will gladly send you a prospectus upon request at no charge. Some will also provide them online, some by mail, and some through a stockbroker. In whatever way you get it, DO GET IT! I repeat, this is always the very first step after deciding you might be interested in investing is a specific fund.

Well, that pretty well covers the basics of mutual fund structure and terms for today. In several weeks, as I said, I will have an article covering the best ways to evaluate mutual funds for your own needs and what methods to use in measuring performance before committing cash to any mutual fund. Watch for it.

Do hope your coming investment week is a good one. In the meantime, you keep in touch. I do. See you next week.

Editor's note:
5 highest yielding, safest investments for 2007
Get our top 4 ETF recommendations for 2007
Bernanke Reveals `Fiscal Crisis` Ahead