Small investor? Stick with funds

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NEW YORK (Money) -- Question: I would like to invest in stocks, but I can't afford to buy large quantities. Earlier this year, for example, I would have loved to have bought Countrywide Financial when it was trading at $8.21 a share, but I only had enough money for 15 to 20 shares. Is there a way for someone like me to buy small amounts of stock a few times a year without getting killed by fees? -J. Parker

Answer: By trading online it is possible these days to buy stocks while holding brokerage commissions to a minimum. Some companies even allow you to sidestep brokerage firms altogether by selling your stock directly through direct purchase plans (DPPs) or Dividend Reinvestment Plans (DRIPs).

But I have two caveats before you sign up with a broker or direct investing plan and start clicking your way to stock-market riches.

First, I think you'll find that the extremely low fees touted by discount brokerage firms often come with restrictions (minimum account sizes, monthly maintenance charges, inactivity fees, etc.) that make super-low commission rates the equivalent of an optical illusion for an investor like yourself who has only a small amount of money to invest occasionally.

The same goes for many direct purchase and dividend reinvestment plans, which often carry a variety of fees and charges that can make them too expensive for someone making infrequent small purchases.

You can judge for yourself, though, by taking a look at Barron's 2007 online broker review and by clicking here.

Now, about that second caveat I mentioned. Even if you are able to find a brokerage firm or direct investing plan with suitably low fees, I don't think you should follow through on your plan to invest small sums occasionally in individual stocks.

Why? Several reasons.

The first is just a matter of expertise. I don't want to suggest that you need to be a rocket scientist to invest in stocks. You don't. But if you're going to buy individual issues, you should have a sense of how to analyze a company on the basis of its earning power and value of its assets and be willing to do enough research to arrive at your own independent judgment of what it's worth - and how that worth compares to its current trading price. If you buy stocks without going through this process, then in my opinion you're not really investing. You're just buying stocks and hoping for the best.

Perhaps you've gone through this sort of analysis in the case of mortgage lender Countrywide Financial (CFC, Fortune 500), and maybe that's why say you wished you'd been able to get into Countrywide at $8.21 a share. But I'm skeptical.

Fact is, $8.21 was the lowest trading price Countrywide's stock reached after investors pummeled the company because of blowups in the subprime mortgage market. After hitting that low on November 20th, the stock rebounded to as high as $12.90 on December 7th after the government began talking about a mortgage bailout plan.

Anyone who bought Countrywide at $8.21 would have looked pretty darn smart in early December. But I can't help but wonder: Are you really savvy enough so that you actually knew back on November 20th that the stock might be a bargain at $8.21? Or did you decide $8.21 a share looked like such a sweet deal after you knew the stock had bottomed out and rebounded substantially?

Only you can know that, of course. But the fact that you've homed in on the stock's absolute lowest point suggests to me that this is probably a case of 20/20 hindsight.

By the way, Countrywide has subsequently dropped back below $8.50 a share. So it still remains to be seen whether anyone who bought at $8.21 and didn't have the smarts - or luck - to get out during the stock's brief rally made a wise move. [Actually, shortly after this column was posted, Countrywide shares were drubbed yet again, dropping as low as $5.05 a share. Maybe you should be glad you weren't able to buy in at $8.21 back in November.]

My point is that it's easy to look backwards and see what the smart move would have been. It's quite another to make the right moves in real time. That requires skill and diligence - and even professional investors who have both those attributes often don't end up doing better than the market indexes.

But even if you are willing to make the effort required to invest in individual stocks and are capable of doing the research, I don't think it's the right way to go for someone of limited means. If you're going to own individual stocks, you need to protect yourself against "specific stock" risk - that is, the danger that, despite your fabulous research and insights, a stock still might blow up on you.

The way to minimize this risk is to spread your holdings among many stocks. You can argue about how many stocks you need to own to have a diversified portfolio, but I'd say you should have at least a dozen and preferably 20 or more. It's hard to assemble that sort of broad portfolio if you're investing only in dribs and drabs.

So what should an investor like you do to participate in the wealth-building potential of the financial markets?

I think the answer is pretty simple: Invest in mutual funds.

By spending just a few minutes on Morningstar's Fund Screener, you can easily find many funds that require a minimum initial investment of $500 or less. (After you get the results from your screen, choosing "Nuts & Bolts" in the "View" pulldown menu will show you each fund's required minimum.) And many fund companies will reduce their minimum even further if you're investing through an IRA account, or if you'll agree to invest a certain amount every month.

If you find a fund you like with a price of entry that's too high - say, several thousand dollars - you can always stick your money in a savings account until you have enough. Once you've met the initial minimum required, you can usually make subsequent investments for a few hundred dollars or less.

So instead of getting a handful of shares of just one stock with a small investment, investing in a stock mutual fund gives you shares in a diversified portfolio of typically 100 or more individual stocks. That doesn't mean the value of those shares won't go up and down the market overall - they will. But by spreading your money among the shares of many companies, you vastly reduce the chances that problems with one particular company (say, a mortgage lending firm whose stock takes a hit during a housing meltdown) will do you in.

Even better, the low investment requirements for funds allows investors who lack big bucks to build a portfolio that includes not just stocks, but bonds. This adds another layer of protection since your financial fortunes aren't riding completely on the performance of just one asset class. (For more on how divvying up your money among different types of investments can enhance returns and reduce risk, click here.

And if you want to really streamline the investing process, you can invest in a type of mutual fund known as a target-retirement fund. You choose a fund with a target date that corresponds to the year you plan to retire (2005, 2025, 2050, whatever) and you get a completely diversified portfolio of stocks and bonds in one fund.

I think these funds are an excellent choice for retirement investing because in addition to giving you a portfolio of stocks and bonds appropriate for your age, the mix automatically shifts more toward bonds as you get older, so that you're taking on less risk as you near retirement and are more concerned with preserving principal.

Click here for more about how these funds work and here for the target-funds that made the cut for our Money 70 list of recommended funds.

If, after building a core portfolio of stock and bond mutual funds you decide you would still like to try your hand at investing in individual stocks, fine, go ahead. (although before you do I suggest you hone your investing skills a bit by checking out our Money 101 lesson on stock investing.) But until then, I recommend that you stick to the safer route offered by funds.