Build Your Own Low-Cost Stock Fund

Small investors face several hurdles when they want to purchase individual stocks instead of mutual funds. Now, there are ways to overcome many of these hurdles.

New research shows you need 40-50 stocks in different sectors for a diversified portfolio. (Older research said eight to 16 stocks.) Buying that many stocks for a modest portfolio means buying small amounts of each stock. Brokers require you to buy whole shares and like you to buy in 100 or more shares. Even at today’s relatively low commission rates, buying only a few shares results in a high percentage of the purchase going to commissions. Making enough small purchases to put together a diversified portfolio gets expensive. Buying enough stocks to replicate a stock index is out of the question.

Technology has changed all that. Now even the smallest investors can buy a diversified portfolio at low cost. You even can buy an entire stock market index.

This is possible through a special type of Internet-based broker, known as a dollar-based or fractional share broker. Some are called “basket brokers.” With these brokers, you don’t have to buy whole shares of stock. You decide how much money to put in a stock, and the broker buys the equivalent amount of shares. You can buy, say, 22.65 shares or even 0.75 of a share. The trading cost is the same, regardless of the number of shares purchased.

Even better, the cost can be very low. Pricing plans vary. You might pay a set fee for unlimited transactions or for a set number of trades, with additional fees for extra trades. Or you might pay a few dollars per trade.

BUYandHOLD (www.buyandhold.com) offers two plans. The Basic Investing Plan costs $6.99 per month. For that you get two buys or sells per month, with additional transactions costing $2.99 each. The Unlimited Investing plan covers all transactions and covers all transactions.

FOLIOfn charges either $29.95 per month or $295 annually. For this you can construct up to three groups or baskets of stocks, called folios, and make unlimited transactions during the twice daily trading windows. You can select from FOLIOfn‘s approximately 100 pre-selected folios. Or you can just select and buy stocks on your own. Stocks that are not on the list of tradable securities can be purchased at a market order for a $14.95 commission.

MyStockFund (www.mystockfund.com) is the newest entrant. For a flat annual fee of $145 you get unlimited monthly purchases. Purchases are made once a month on a scheduled date. Sales cost $18 per transaction. You can have a fixed amount drafted from your checking account each month and automatically invested in your stocks in pre-determined amounts. I am on the Advisory Board for MyStockFund and have a small equity interest. Dividends can be reinvested automatically.

Sharebuilder (www.netstock.com) also offers an unlimited plan for $12 per month. Or you can opt for “pay as you go,” paying $4 per transaction. Sharebuilder also lets you buy or sell in real time at either a market or limit price for a $15.95 per transaction.

These brokers generally are attractive to longer-term investors because they have restricted trading windows. Trading windows are at certain times during the day, weekly, or monthly. The trading limits are necessary to allow sales and purchases of fractional shares and keep costs low. Transactions must be grouped so that whole shares can be traded with outsiders. These brokers are not for someone who wants to trade frequently, want a specific price or who is looking for the best price of the day.

The programs are ideal for those making regular monthly investments and who plan to hold the stocks for a long time. If you are looking for a way to build a portfolio for a family member, such as a grandchild, consider these brokers. You could invest as little as $10 monthly (automatically drafted from your bank account). These brokers also can be ideal for long-time mutual fund investors who want to dip their toes into individual stocks.

A modest investment each month purchases a diversified portfolio. You could even replicate a market index, such as the S&P 500, with a small investment.

But be sure to compare the trading cost with the amount you plan to invest. FOLIOfn’s $295 annual fee comes to 29.5% of a $1,000 investment. You want to invest enough in your chosen broker to keep the expense ratio reasonable.

Dollar-based brokers are an important development at a time when mutual funds are shunning the small investor.  Vanguard’s minimum investment generally is $3,000. Most funds raised their minimum investment amounts in recent years. Most recently, TIAA-CREFF increased its minimum investment to $1,500. The only mutual fund I know that offers quality funds and caters to the small investor is American Century.

You could make similar small, low cost, fractional share purchases through the direct stock purchase plans of many companies. But not all companies have direct purchase plans. Many of those that do are trying to get out of the business or are raising fees.

In addition with direct purchase plans you’ll have a separate account at each company. It will take time and effort to collate the statements, analyze your portfolio, and make trades. All the dollar-based brokers are Internet-based. You easily can view your entire account, track performance, and make trades.

That leaves one problem for the small investor: selecting the stocks to buy. Each site offers research online. Most offer pre-selected portfolios or baskets of stocks. You can pick a market index or a portfolio of stocks with certain characteristics. Or you can use the research tools to develop your own portfolio. Most of the brokers also have screening tools that let you to select the characteristics you want in stocks (such as companies of a certain size with low price-earnings ratios), then review a list of those stocks.

Financial stability is a concern with some of these brokers. Netfolio went out of business a few months ago. FOLIOfn recently laid off a number of staffers. The others appear to be more financially secure, but BUYandHOLD increased its fees recently.

Another benefit of owning individual stocks instead of mutual funds is that your tax burden can be controlled. Capital gains are taken when they suit you, not a mutual fund manager. You also can go through the portfolio each year and take losses to meet your needs.

The dollar-based brokers meet two of my basic investing principles. They reduce costs, and they simplify investing. Combine those benefits with the low minimum initial investments and monthly investments, and they are a great way to begin investing in individual stocks or to build a long-term portfolio, especially for a youngster.