Character encoding is important to display a text correctly on the computer. When you create a textfile, there has to be an information about how it has to be encoded. If the wrong encoding is used, symbols like squares or questionmarks are shown instead of the correct letters.

The first step is to know which characters you want to use. There are different collections of character sets, that are encoded by associating each character to a number. There are also different ways of encoding them. 

One of them is the ASCII (American Standard Code for Information Interchange), which is used with different extensions for different character sets.

The most commonly used encoding is UTF-8, which encodes Unicode characters. It's highly recommended to use this encoding. In almost every word processor program UTF-8 is used as default character encoding. Although it's possible to change it (usually via the "Save as.."-Menu), you should stick to UTF-8, because it guarantees inter-operability and the longest possible term of readability. 

You can find a list of encodings that should be avoided at any rate at the W3C website.