Information on investing can often be somewhat dry and technical, but when your money is on the line, you should always be informed about your options. This article will explain to you, in plain language, two of the most popular forms of investing: index funds and mutual funds - as well as tell you which one you really should probably use.

Index funds and mutual funds can both be thought of as baskets filled with various stocks or bonds – but here we will focus on funds containing stocks. Now, a stock is simply a piece of a company. A stockholder is no different than a partial owner of a company, except that in most cases a stockholder owns a tiny piece of the company and for that reason doesn’t get to be involved in everyday decisions about the company’s operations, like a normal owner would; however, because stockholders are partial owners, like owners, their piece of the company increases with value when the company is doing well and decreases in value when the company is not.

So, index funds and mutual funds really just own pieces of other companies, they themselves don’t actually do or make anything, other than decide which stocks to buy, and it is here that the difference between index and mutual funds shows itself.

Index funds are so named because they attempt to mimic the performance of a specific financial index. A financial index is just a number that is derived from combining the values of whatever composes the index. To illustrate the point, when a news anchor says, “The market was down 15 points today,” he is often referring to the S&P 500.

The S&P 500 is an index containing the stock of 500 large corporations. When, on average, the value of these corporations decreases, so does the value of the S&P 500 index. If you bought an index fund that was based on the S&P 500, its movement would replicate almost exactly the movement of the S&P 500. The original idea behind an index fund was literally to be the S&P 500 – except that investors could purchase a piece of it. Of course, you can purchase index funds tied to numerous different indices besides just the S&P 500, such as the Wilshire 5000 and FTSE 100 among others.

Mutual funds are much different. It is easier to understand what they do, but harder to understand how they do it. Now, bear with me. A mutual fund is managed or controlled by a group of people. These peoples’ entire job consists of deciding what stocks to buy. Unlike an index fund, a mutual fund does not need to mimic a particular index, and therefore a mutual fund is free to buy stocks based on different investment strategies. So in other words, the group of people that manage a particular mutual fund buy stocks they like for the mutual fund, it is that easy. However, why they like certain stocks and not others is hard to explain and often doesn’t seem to have a real explanation.

Some groups of people who run mutual funds do “value investing;” they only buy stocks that seem to be a great deal. Others do “growth investing;” they only buy stocks that are in a business that is really booming. Others combine both methods… and the list goes on.

For the purpose of this article, the particular investing style a mutual fund uses doesn’t matter much because in the end they are mostly wrong. That’s right, most mutual funds underperform the market, and since you can basically receive market returns through an index fund, an index fund makes more sense.

There are two main reasons index funds make you, the investor, more money. First, in all honesty picking winning stocks, stocks that are going to go up in value faster than the average stock, is really quite hard on as large a scale as mutual funds need having millions of dollars to invest. Very few people are able to analyze and interpret data about a company’s orders, costs, debt, outlook, management, macroeconomic issues as well as countless other variables.

Now, if picking winning stocks is that hard both index funds and mutual funds should do about the same because it is all luck anyway and they both have some stocks - and who knows how any particular stocks are going to do, right? Well, because it is so difficult to determine what stocks are going to do, that argument would be right except remember that group of people I talked about who decide what stocks a mutual fund buys? Well, those people want to get paid, in fact they want to get paid a lot.

According to data, the average mutual fund manager makes almost a half million dollars a year and these high salaries are reflected in higher fees for mutual funds. Also, the buying and selling of stock carries associated costs which are more likely to occur with a mutual fund. These differences show up in the comparison between index funds and mutual funds time and time again.

In fact, according to most reliable data, index funds outperform some 80% of mutual funds on both a before and after tax basis. That means 8 out of 10 times you are better-off being in an index fund than a mutual fund. So the next time you see an add for a mutual fund, consider whether you would like to bankroll some fund manager’s million-dollar lifestyle or your own? If you choose your own, choose an index fund.