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I'll let you in on a little secret about investing: It's not nearly as hard as you think.

However, the fact that most people do it badly might lead a reasonable person to believe the opposite.

How badly? A study by Dalbar, a Boston investment research firm, found that from 1988 to 2008, when the Standard & Poor's 500 Index ($INX)grew at an average annual rate of 11.8%, individual investors in equity mutual funds saw average returns of 4.5% a year, before taxes. That's downright pitiful.

So with the bar set appropriately low, I'm going to show you a method for starting and managing a portfolio that requires very little money -- you can start with as little as $100 -- even less effort, minimizes taxes and transaction fees, and is likely to outperform 90% of mutual funds over the long haul.

So many investors, so little profit

But first, let's look at the reasons for the awful performance of most investors. There are as many reasons as there are overpaid CEOs, of course, but here are the primary culprits:

  • Market timing. A lot of investors believe there's a right time and a wrong time to invest in stocks, and that it's possible to predict which is which. According to a classic study by William F. Sharpe, Nobel Prize-winning economist and a founder of Modern Portfolio Theory, a person who attempts to time the market needs to be right roughly three times out of four to match the performance of a buy-and-hold investor. Given that the market tends to make major moves in response mainly to unexpected events, that can be a tough mark to hit, as the dismal record of individual investors demonstrates.
  • Buying high and selling low. This is one consequence of failing to time the market correctly, and it most often results from investors chasing the latest hot stock or mutual fund. Investments with the biggest gains will often turn out to suffer spectacular losses as well, leading to panic and a decision to sell at or near the bottom. A portfolio's tendency to rise and fall in dramatic fashion is called volatility and is to be devoutly avoided by those who like to sleep at night.
  • Failure to diversify. Most often, the product of an accumulating pile of company stock, usually in a 401k, can also reflect a poor understanding of different types of investments and how they move in relation to one another. Diversification and strategic asset allocation are the keys to minimizing volatility while maximizing returns.

So what is this strange voodoo called asset allocation? It's a method for spreading your investment dollars across different types of investments (while diversification usually means buying a variety of securities within each investment type). It's also the core of Modern Portfolio Theory.

And before you fall asleep on me, let me show you just how well it works. Roger C. Gibson, the author of "Asset Allocation: Balancing Financial Risk," conducted a 35-year study of the performance of a variety of diversified portfolios. The simplest of these, for illustration purposes, consists of 25% each of four major asset types:

If you had invested $10,000 in each of these asset classes in 1971, you would have seen an 11.6% annualized return over 38 years, including the most brutal decade for investors since the Great Depression.

Taming the bear

When the third edition of Gibson's book was published in 1999, near the end of a 16-year bull market, the value of the equal-weight portfolio was running neck and neck with the sizzling-hot S & P 500. Just 10 years later, the diversified portfolio is worth 77% more than the stock-only portfolio. It's during bear markets that asset allocation really makes a difference.

The key to success is finding asset classes that tend to respond differently to the economy's ups and downs. For example, in 1973 and 1974, when domestic and foreign stocks and real estate fared badly, commodities soared. Over the next two years, commodities tanked while stocks and real estate gained substantially.

But what do you do if you're just getting started and have only a few hundred, a thousand or maybe a few thousand dollars to launch your assault on the capital markets? Fear not! The range of low-cost mutual funds and other instruments available to you has exploded in recent years, and I'm going to give you a step-by-step guide to building a smart, secure and properly diversified portfolio. This strategy works for building a portfolio with any amount of money, and it's great for those starting small.

Investing on a shoestring

So let's say you get a $100 tax refund and want to start investing. The simplest course is to open an individual retirement account at any of the big discount brokers and commit to investing $50 or $100 a month in a mutual fund. The hard part is deciding which of more than 8,000 funds is worthy of your money and will be adequately diversified. I have nothing to recommend for this approach, because I haven't yet found any no-load funds that include significant allocations to commodities and real estate. Nor do many fund managers follow the kind of consistent discipline that Gibson's data would support.

The alternative -- and the course I recommend and follow personally -- is building your own portfolio with exchange-traded funds, or ETFs. These are instruments that trade like stocks and mimic the behavior of a variety of different types of assets (stocks, bonds, real estate or commodities) and are typically designed to track an index, such as the S & P 500, iShares MSCI EAFE Index (EFA) or Russell 2000 Index ($RUT.X).

In order to make this approach work for the small-dollar investor, it's vital to keep transaction costs as low as possible. I've found only two brokers that have no minimum account size and charge only a small commission for each security purchased: ShareBuilder, at $4 per trade, and Zecco, at $4.50. It's worth noting that ShareBuilder charges $9.95 to sell shares, while Zecco sticks with its $4.50 pricing for all trades. (And once your account value reaches $25,000 -- and it will get there if you stick with it -- Zecco will give you 10 free trades a month.)

In order to minimize your trading costs, you'll want to rotate your initial purchases among the following ETFs, which invest broadly in each of five major asset classes:

  • Rydex S&P Equal Weight (RSP), which invests equal sums in the stocks of the 500 companies in the S & P 500.
  • Vanguard FTSE All World ex-US (VEU), which tracks an index of more than 2,200 companies in 46 countries outside the United States.
  • Vanguard Total Bond Market (BND), which tracks the price and yield performance of the total U.S. market for corporate and government bonds.
  • Vanguard REIT Index (VNQ), which tracks an index that represents about two-thirds of the value of the U.S. real-estate investment trust market.
  • PowerShares Deutsche Bank Commodity (DBC), an index of futures contracts for the 14 most heavily traded commodities in the world, including energy, metals and agricultural products.

If you're able to invest only $100 a month, it would be wise to make a single quarterly purchase of $300, rather than monthly purchases, so that your trading costs take only about 1.3% of your investment dollars, rather than 4%.

Regardless of how you do it, though, it won't take long to build a portfolio that will ride out the market's ups and downs a lot more smoothly than most.

Rebalance yearly

As time goes on, you'll find that some of your investments have grown in value while others have lost money or stayed about the same.

For this simplified example, let's suppose that by the end of the first year you've invested a total of $1,000, putting $200 in each ETF. To keep things simple, let's say your U.S. stock holdings have increased 30% in value, while your foreign stocks have declined 5%. There, on the bottom line, is a $50 profit! Your portfolio is now worth $1,050 and looks like this:

Exchange-traded fundValue after 1 year% of portfolio
Rydex S&P Equal Weight (RSP)$26025%
Vanguard FTSE All World ex-US (VEU)$19018%
Vanguard Total Bond Market (BND)$20019%
Vanguard REIT Index (VNQ)$20019%
PowerShares Deutsche Bank Commodity (DBC)$20019%
Total value$1,050100%

But now you've got more than your target of 20% in U.S. stocks and less than 20% in the other asset classes. To restore your portfolio to its target percentages, you'll need to sell $40 worth of RSP and buy more of the ETFs that have performed less well to bring them up to 20%, or $210 each. (This isn't as dumb as it seems at first blush: It disciplines you to buy more when prices for an asset class are low.)

A typical real-world allocation would be something like the one I use: 20% U.S. stocks, 22% non-U.S. stocks, 30% bonds, 17% real estate and 11% commodities. A younger investor with a higher risk tolerance might want to reduce the bond component to 10%, while a retired person with lower risk tolerance might want to raise the bond allocation as high as 50%. Bonds tend to reduce the overall volatility of a portfolio and mitigate risk, which is especially important for retirees.

Once you've established your target allocations, stick to them. Succumbing to the temptation to guess what the next hot asset class will be is your surest ticket to mediocre returns. And keep investing through the down markets, especially, because that's when your discipline will pay off with higher returns down the road.