Building a Portfolio on the Cheap

Anyone who knows anything about investing—from your old high school business teacher to financial guru Suze Orman—will tell you that the earlier you start putting money in the stock market, the better. That's because of the money miracle of compounding. An initial investment of $5,000 earning 7 percent a year will be worth about $19,300 after 20 years but nearly $75,000 after 40 years, excluding taxes.

Jason Barnette does his stock homework.

(Jeffrey MacMillan for USN&WR)

But you don't need to be thinking about life in 2048 to get motivated to start investing ASAP. Just look at the business headlines. Fears of a recession have hammered the market. To turn it around, that means stocks are on clearance. "This is a time to get excited, because you can pick up shares at bargain prices," says Elizabeth Ruch, a senior financial adviser with Waddell & Reed in San Diego.

With investing, your first priority should be contributing to your 401(k) or an individual retirement account. But you may also want to invest for other goals. "Some people come to me at 30 years old and don't have a penny to their name except for what's in their 401(k)," Ruch says. "That's not of value if you want to buy a house." Ideally, she says, young investors should set aside money in at least three pools: a cash account for emergencies and short-term splurges, a portfolio for a medium-term goal such as buying a house, and a long-term retirement account. Here's a step-by-step guide on how to build a portfolio on the cheap.

Core choice. One of the easiest routes to a diversified portfolio is through a no-load mutual fund, which charges no sales commission. Eventually, you'll want to own several funds representing different asset classes and investing styles. But for now, pick one with a broad selection of stocks and low expenses, such as Schwab Core Equity. For an initial investment of $100 and 0.75 percent in annual fees, you get exposure to 110 large and midsize companies in every major economic sector.

Schwab Core Equity's expenses are low, in part, because the fund uses a computer model to pick stocks. The average actively managed stock fund—which employs professional stock-pickers—charges 1.44 percent in annual fees, according to Morningstar. With active funds, you pay a premium in the hope that your manager will outrun the market.

Index funds, on the other hand, are cheap because they make no effort to beat the market—they simply match the performance of an index, such as the S&P 500. But don't call them underachievers: Rock-bottom expenses (0.76 percent on average) are their biggest draw. "Focus on what you can control: minimizing fees and expenses," says Rudy Aguilera of Helios, an Orlando investment advisory firm. "You must be vigorous, because every dollar you pay in fees and expenses will reduce your returns dollar for dollar." Aguilera is a fan of exchange-traded funds, which offer the diversification of mutual funds but can be bought and sold like a single stock. Think of ETFs as even lower-cost cousins of index funds: With a few exceptions, ETFs mimic market indexes.

Automatic investing plans are terrific for young investors. Contributing a set dollar amount each month reduces the risk that you'll invest all your money before the market tanks. Auto-investing plans also give you access to mutual funds that normally require steeper initial investments. For example, T. Rowe Price, which requires an initial $2,500 for regular accounts, will let you into its funds for just $50 if you agree to contribute regularly. American Century's gen Y-flavored "My Whatever Plan" asks for $500 upfront and a subsequent $100 monthly investment for a premixed portfolio of funds.

Perhaps the most important decision you'll make as an investor is how you divvy up your money among stocks and bonds. Over the long haul, stocks provide the best returns. Since 1926, stocks have returned an annual 10 percent, according to Morningstar. During the same period, bonds gained an annualized 6 percent, and cash, just 4 percent. With inflation averaging 3 percent annually since 1926, your real, after-inflation return drops to 7 percent for stocks, 3 percent for bonds, and just 1 percent for cash.

Bonding. Don't assume that you need bonds: Young investors with decades of compounding growth ahead of them can afford to put all their money in stock funds, says Ruch. One consideration, however, is how soon you'll need the money. If you're planning to buy a house within the next three to five years, preservation should be your top priority, says Norm Mindel, a financial planner with Genworth Financial. "In this case, you'd probably want 50 to 60 percent in fixed income and 30 to 40 percent in stocks," he says. "You have to be cautious when you're trying to accumulate money for a short-term goal." That portfolio might be too bond heavy for some investors, even with a short time horizon. In deliberating over your stock-versus-bond breakdown, factor in your feelings about losing money. If you break into a sweat with each market drop, a 100 percent stock portfolio probably isn't for you.