There are three sensible ways to go about starting your portfolio. The first is to invest in a fund that holds both stocks and bonds. Why? Because investors are their own worst enemies: we perpetually overestimate our willingness to suffer losses, buy investments that are riskier than we’re ready for and sell in a panic when we see 30 or 40 or 50% of our capital evaporate. Studies show that investors typically make less money than the funds they invest in because they tend to sell at the worst possible moment. A good way to decrease the temptation to sell is to decrease the fund’s volatility, which is what occurs when you mix different asset classes (for example, domestic and foreign stocks, bonds, cash and real estate) together in the same portfolio. And, too, there have been extended periods when the other asset classes outperformed stocks! Here are two funds to consider.

Pax World (PAXWX) invests about 60% of its money in stocks and 40% in bonds. The fund is "socially responsible," which means that it avoids investing in companies that are involved with weapons, liquor, tobacco or gambling. Their objections to such investments are both ethical and practical (it’s not good to invest in companies that get sued a lot). The fund has returned an average of 20% over the past three years, which places it in the top 10% of its peer group. Its five-year record is 18% return, top 5% of its peer group. And, during market declines, it places in the top 10% of all funds. The minimum initial investment is $250.

TIAA-CREF Managed Allocation (TIMAX) is a slightly different creature. Rather than invest directly in stocks and bonds, it invests in other TIAA-CREF mutual funds. That allows the fund to offer an enormous amount of diversification (you’re buying parts of about 1000 stocks and 50 bonds) with exceedingly low overhead expenses, about 0.4% per year. Currently 40% of the assets are invested in Bonds Plus, 25% in Growth Equity, 25% in Growth and Income and 10% in International Equity. During 1998, its first full year of operation, the fund returned 21.5%, which places it in the top 10% of its peer group. More information about the TIAA-CREF funds shows up about two paragraphs below. The minimum investment is $250 or $25 if you’re willing to commit to making a monthly investment of at least $25. That’s called an automatic investment plan (AIP).

Your second strategy is to begin is with a low-cost index fund. Why? A number of factors depress the returns of actively-managed funds: their operating expenses eat up 1.5% of the fund’s assets each year, their managers invest only a fraction of the money entrusted to them and keep the remainder in low-yielding money accounts, frequent stock trading both affects the prices of the stocks (for example, trying to sell a bunch of one particular stock will tend to drive down the stock’s price and hence its value to the fund) and creates tax burdens for the investors. Index funds offer broad diversification with little of the drag of expenses that an actively managed fund imposes. Traditionally these funds have not been available to small investors because the high costs of maintaining small accounts have eroded the funds' cost advantage. T. Rowe Price offers a compromise: access to any of their index funds with a quarterly service charge of $2.50 for accounts under $10,000. Price offers three index funds: Equity Index 500 fund (PREIX), Total Equity Market Index (POMIX, which tracks the Wilshire 5000 index of all stocks) and Extended Equity Market Index fund (PEXMX, which tracks the Wilshire 4500 - that is, the total market minus the S&P500). These funds promise low expenses (0.40%), low portfolio turnover, high tax efficiency and market-matching performance. $50/month minimum investment with an automatic investment plan, plus $2.50 per fund per quarter for accounts under $10,000. Links to other low-minimum index funds can be found at www.indexfundsonline.com.

A third alternative, one that captures many of the advantages of the index funds, are the new TIAA-CREF mutual funds. TIAA-CREF runs the world's largest private retirement system (for teachers and other employees of non-profits) whose variable annuity accounts have all earned four or five stars from Morningstar. CREF has recently opened a handful of low cost, low-investment mutual funds to the public. Each fund consists of two parts. One part aims to match the fund's benchmark index, both in risk and in returns. The other part consists of actively managed investments that the managers believe will outperform the market. The indexed part can constitute anything from 30-80% of the funds' investments. As managers find more good investment ideas, the indexed part will shrink. When they don't find great opportunities, the indexed core will grow. Like an index fund, you can expect very low expenses, low turnover and high tax efficiency. Two funds to consider: Growth Equity (TIGEX) whose indexed component matches the Russell 3000, returned 36% in 1998 and Growth and Income (TIGIX), whose index is the S&P500, returned 30.5%. Both funds beat the SP500 and their peer groups. Expense ratios range from 0.43-0.45%. Minimum investment is $250 for a one-time investment or $25/month with an AIP.

If you simply want to look at good funds with good track records, the most sensible place to start are with the large company funds. Large caps, such as the S&P 500, account for more than 75% of the total value of the U.S. stock market and should probably hold a similar weighting in the average investor’s portfolio.

I was once told that you should never invest with a manager who didn't have some sort of unfair advantage over the competition. If you just choose a reasonably bright manager with reasonable expenses and a reasonable strategy, you'll end up with more-or-less index-like returns. To outperform the index, a fund needs either great luck (which is hard to bank on) or an unfair advantage: a genius manager, remarkably low expenses, an investing strategy that is unique and so on. What I've tried to highlight in this section are some successful funds which seem to have that sort of advantage.

American Century Income and Growth (BIGRX) combines value and momentum strategies. This former Benham fund, which Morningstar has described as an "oasis of calm" in a stormy market, searches through a database of the 1500 largest US companies for those with low prices and some combination of earnings momentum and positive surprises. Apparently few value funds pursue this discipline. Made 27.7% in 1998, which placed it in the top 4% of large value funds – it has been in the top 5% pretty consistently. Has matched the SP500 over the past one, three and five years, with below average volatility. The portfolio is large (271 stocks) and pretty actively traded (102% turnover). One caution: the assets under management are rising quickly. $50 AIP, $1000 IRA, $2500 otherwise.

Dreyfus Appreciation (DGAGX) invests in humongous corporations. Dreyfus bought the fund in 1990 and installed their star manager Fayez Sarofim. The portfolio turnover rate dropped from an average of 150% to 1% and the expense ratio declined steadily. At the same time, the number of companies in the portfolio fell while their size rose. The fund invests now in humongous companies (the median size is $82 billion) and keeps a fairly compact portfolio (72 stocks, with over 5% in Pfizer). The manager's philosophy is to invest in world-class firms and hold on. That makes from great tax efficiency and modest risk. Returned 30.8% in 1998, a bit below the large-growth average but well above the SP500. $100 AIP, $750 IRA, $2500 otherwise.

Excelsior Value and Restructuring (UMBIX) invests in corporate turnarounds. It is akin to BGIGX in that the manager is a value player who looks for an edge. In this case, UMBIX invests firms that are in the midst of restructuring (mergers, liquidations, bankruptcies, consolidations, spin-offs) which should serve as a catalyst for more growth. The fund moves between the mid- and large-cap range (about 60% of the portfolio are now large caps), is highly tax-efficient, has low and dropping expenses and a small asset base. Up 10.3% in ’98. Top 5% of mid-blend funds over the past 5 years. $50 AIP, $250 IRA, $500 otherwise.

Legg Mason Value (LMVTX) deserves a look for its remarkable record: it has bested the SP 500 every year since 1991 and has managed to do so with only average risk. The fund returned 48% in 1998, nearly 20% over the SP500. The strategy followed by manager Bill Miller (Morningstar’s 1998 Manager of the Year for domestic stock funds) is to buy a small number (about 50) of good companies and hold on even when their valuations move them out of the "value" category (AOL is about 10% of the portfolio). The fund has low turnover and high tax efficiency, although the expense ratio remains higher than it should be (1.73% on six billion-dollar asset base). $50 AIP, $1000 otherwise.

At this point, I should admit that I’m a sucker for Price funds. A lot of the time it seems like they don’t have any funds I’d want to avoid and they have a whole raft of strong large cap funds. I’ll mention just one and then be quiet.

T. Rowe Price Dividend Growth (PRDGX) pursues large companies whose dividends have grown steadily, which means they're into good, steadily growing firms. The manager is more value-conscious in a frothy market. As a result it's in the bottom fifth of large-blend funds for 1998 with a 15% return. A weak performance in 1998 has pulled its record down, though it still sports one of the highest risk-adjusted returns of all low-minimum funds. Its low risk scores and generally strong performance during down markets makes it a good defensive option. As with all Price funds, minimum is $50 with an AIP, $1000 IRA, $2500 otherwise.

Smith Breeden U.S. Equity Market Plus (SBEPX) is perhaps the strangest creature in this collection. This fund owns no stocks. Its portfolio consists entirely of cash (17% - which is used to buy S&P futures) and mortgage-backed securities (83%). I don’t entirely understand it, but commentators believe that the strategy carries no greater intrinsic risk than a regular index fund. The key to the fund’s ability to beat the SP 500 is the ability of the mortgage-backed securities to outperform Treasuries, which they normally do but haven’t lately. They returned 26.4% in ’98, about 1.5% behind the SP 500 but still in the top 15% of large-blend funds. $50 with an AIP, $500 otherwise.

Up until now, the list has focused on large cap funds. And with good reason: large cap stocks represent the vast bulk of total stock capitalization and these mature firms tend to provide strong, consistent returns. There is an argument, however, for looking at slightly smaller companies. Research cited by T. Rowe Price shows that midcap firms offer noticeably higher long-term returns with only modestly higher risk than do large caps.

Three midcap funds worth considering:

The Muhlenkamp fund (MUHLX) is run by Ron Muhlenkamp. It's his only fund and it's where he has invested most of his personal wealth. The fund invests in low P/E and low P/B companies that show high return on capital. Until 1998 – when midcap value funds were one of the market’s weakest groups and the fund returned 3.2% - the fund had bested the S&P500 with noticeably less volatility. Even so, it has been in the top 20% of mid-cap value funds for the past 3, 5 and 10 years. The minimum purchase, with or without an AIP, is $200 though they’re thinking of raising it!

T. Rowe Price Value (TRVLX) is run by one of Price's best value managers, Brian Rogers whose other charge is the outstanding Equity-Income fund. Rogers believes that investors are actually willing to take on much less risk than they think they are and positions his funds accordingly. Value is a true mid-cap fund, leaving small value issues to Price's Small Cap Value fund and most large value issues to Equity Income. Value has a low correlation to the S&P500 (.76), which makes it a good source of diversification. During 1998, the fund returned 6.9%, in the top fifth of mid-value funds while its 3-year record places it in the top 15%. The minimum purchase is $50 with an AIP, $1000 IRA, $2500 otherwise.

T. Rowe Price Mid-Cap Growth (RPMGX) is run by one of Price’s best growth managers, Brian Berghuis. Berghuis is steered this fund to a remarkable record: top decile long-term performance with the lowest risk scores in his peer group. Lately the fund has been merely above average rather than outstanding (up 22% in ’98), but that reflects Berghuis’s unwillingness to follow the crowd: the fund holds less tech, buys less-pricey stock and has a smaller market cap than most of its peers. It’s also among the most tax efficient of the midcap growth funds. The minimum purchase is $50 with an AIP, $1000 IRA, $2500 otherwise.

Summary of Core Funds - through 12/31/98

The justification for adding a fund to your portfolio is to improve your risk-adjusted returns. You might do that by investing in sectors riskier than your core holdings, in hopes of boosting returns. Or you might do it by investing in funds less risky than your core, in hopes of dampening volatility. The psychological argument for diversification: you’re less likely to panic and do something ill advised as long as some of your investments seem to be holding up. In either case, you want to base your decision on a judgment about what role the fund will play in your longer-term strategy, rather than just whatever fund is hottest or most favorably discussed by the folks on the Web.

If your core equity funds are large-cap and domestic, then you can diversify your portfolio by adding smaller cap funds, international funds, or some combination of the two. One measure of the diversification value of a fund is its correlation to the broad stock market, a statistic called the "R-squared" or R2. An R2 of 90 suggests that the movement of the S&P500 can explain about 90% of the movement in a fund’s value. By and large, these funds tend to be more volatile than the core funds discussed above, which means that you want to be careful with your research and cautious about the amount of money you choose to commit to them.

Small cap funds. Over very long time frames, very small companies have outperformed large ones by two percent a year (though there is debate about whether that superiority is a statistical or historical fluke). At the very least, there’s no reason to believe that small companies will underperform large ones and their price movements are only weakly related to large cap indexes.

We’ll start with small cap value funds. This is a hard area to find good funds, since this arena seems to require nimble funds with very small asset bases. As a result, the best funds close quickly (though several have reopened after 1998’s small cap bear market). You might want to take the risk of trying young funds from good families, even when they lack a track record. There are at least three good candidates still available:

Artisan Small Cap Value (ARTVX), a year old, is managed by Scott Satterwhite, who built an outstanding record running Biltmore Special Value. The fund is too new to have a reliable track record, but its performance so far and Satterwhite's history makes it worth considering. Lost 5.8% in 1998, about a percent better than its peers. $50 AIP, $1000 otherwise.

Eclipse Equity (EEQFX), run since 1987 by Wesley McCain, has earned Morningstar's highest category rating for a small value fund and is coming off a strong three-year run. The fund returned 3.4% in 1998 (versus a 7% loss for its peers). Its 3-year return is in the top 5% of small value funds and offers slightly below-average risk. $50 AIP, $1000 otherwise.

Lindner/Ryback Small Cap (LDRSX) has put together fine long-term numbers (top 10% of its peer group over the past three years) with three important distinctions. First, it has consistently shown below-average risk - only about 70% of the volatility of the Russell 2000 index. Second, it charges well below-average expenses (0.87%, against a peer average around 1.5%). Third, it operates one of the very few concentrated small cap portfolios. It holds only 35 stocks, one half of Artisan’s portfolio and one-tenth of Eclipse’s. Like Artisan, about three-quarters of its portfolio are in microcap stocks. $50 AIP, $250 IRA, $3000 otherwise.

Three strong, but somewhat more aggressive small cap funds:

Price Small Cap Stock (OTCFX) is a very consistent small cap blend fund, finishing in the top half of its peer group every year since ‘92. Avoids big sector bets, careful of valuations. Dropped 3.5% (peers lost 5.5%) in 1998. Assets are growing at a manageable rate, below average expenses. 3-year return is in the top third of its peer group. Minimum: $50 with an AIP, $1000 IRA, $2500 otherwise.

Fasciano (FASCX) is Morningstar’s lowest risk small blend fund, with a record of doing well in choppy markets. It made 7.2% in 1998 while its peer group lost 5.5%. Tiny asset base ($193M) and reasonable expense (1.40). Minimum: $50 with an AIP, $1000 otherwise.

Fremont US Microcap (FUSMX) returned over 100% between 1995-96. Manager is experienced and well respected; has done institutional money management for decades. The fund has fallen on hard times in '97 and '98 (it returned 2.9% in ’98, several points above average). I'd be reluctant to write it off; manager Robert Kirn played a good bit with the portfolio and saw a 40% return in the 4^th quarter of 1998. Minimum: $50 with an AIP, $1000 IRA, $2000 otherwise.

International funds. Other mature markets will, over the long term, produce returns similar to the US market with similar volatility. Immature markets carry the potential for stunning returns (and equally stunning losses). Generally, neither is closely correlated to the US market except in times of high US volatility. You may already have a noticeable international stake, since the domestic core funds listed above have between 2-20% of their portfolios in international stocks, with most (including the S&P indexes) at 5-6%.

I would seriously consider TIAA-CREF International Equity (TIINX). Like all TIAA-CREF funds, International Equity mixes an indexed core (the Morgan-Stanley EAFE) and an actively managed component. Because of its indexed core, the fund holds much more exposure to Japan (about 15% of the portfolio) than most of its peers. Its expenses are very low (0.49%) and CREF’s Global Equity variable annuity has earned a five-star rating from Morningstar. International Equity returned 19.3% in 1998, which placed it in the top 15% of its peer group. $25 AIP, $250 otherwise.

UMB Scout Worldwide (UMBWX) offers international investing for the timid. Instead of investing directly in the stock of foreign companies, Scout invests in American Depository Rights (ADRs) which trade on the New York Stock Exchange. This means the fund invests mostly in large, well-established firms and avoids the currency risk caused by a rising US dollar. Combined with a low portfolio turnover rate, it also means that the fund can charge expenses that are much below average: about 0.83%. This low-risk strategy places Scout’s returns in the top 7% of its category over the past 3 years, with a 1998 return of 18%. $100 AIP, $250 IRA, $1000 otherwise.

Slightly more risk-tolerant investors might look at American Century International Growth (TWIEX). TWIEX focuses on companies which show accelerating earnings and carries the group’s heaviest weighting in European stocks. That gives it below-average risk and very high returns. Its high portfolio turnover rate cuts into its tax efficiency: its pretax return of 17% places it in the top 6% of international funds, but the returns are cut by 3% when taxes are considered. The fund returned 19% in 1998. $50 AIP, $1000 IRA, $2500 otherwise.

Finally, Artisan International (ARTIX) has shown flashes of brilliance in its short life. The fund, run by veteran manager Mark Yockey (Morningstar’s 1998 Manager of the Year for international funds), is not quite three years old. In 1996 and 1998, the fund had returns in the top 3% of international funds. In 1998, the fund returned 32%. In 1997, though, the fund had slightly below-average returns. Yockey tends to pursue somewhat smaller, somewhat out-of-favor stocks. Though he focuses on Europe, it’s often on Europe’s less-known markets (e.g., Finland). $50 AIP, $1000 otherwise.

The criticism of most international funds is that they offer a very limited advantage over a domestic-only portfolio. The bulk of their money goes to large, European multinationals, whose growth prospects and economic cycles are very similar to large American multinationals. The greatest diversification benefits lies in small companies and small markets.

Founders Passport (FPSSX) focuses on small, high-growth companies (often in the tech sector, seldom in Asia) and is one of the very few international small cap funds with a track record. 3-year return: 11.7%, top third of international funds. Modest volatility, average expenses. Minimums: $50 with an AIP, $500 IRA, $1000 otherwise.

Invesco European Small Company (IVECX) returned 31% in ‘96, 50% more than the average European fund, though it lost 3% in 1997 and made only 8% in 1998. 3-year returns: 11.4%. $50 AIP, $250 IRA, $1000 otherwise)

None of the available diversified emerging market funds have been around for more than a year or two, so I’m reluctant to make recommendations though I will list the options later.

This list contains the names of over 150 funds which satisfy four conditions: no load, available to any investor, requiring no more than $500, and have not received a peer rating of average or below from Morningstar. These funds have either received an above average or high peer rating from Morningstar, or they are too new to have been rated.

AmCent Select Inv, AA, 1000/1000/50

Large Blend

Dreyfus Appreciation, HI, 2500/750/100

Dreyfus Disciplined Stock, AA, 2500/750/100

Dreyfus S&P500 Index, HI, 2500/750/100

Dreyfus Large Company Stock, AA, 2500/750/100

MSB, AA, 250/50/50

Smith Breeden U.S. Equity Market Plus, HI, 2500/500/50

Strong Equity Income, 2500/250/50

Strong Growth & Income, 2500/250/50

TIAA-CREF Growth & Income, 250/0/25

TRP Blue Chip, AA, 2500/1000/50

TRP Dividend Grth, AA, 2500/1000/50

TRP Equity Index, HI, 2500/1000/50

Large Value

AmCent Equity Growth, HI, 1000/1000/50

AmCent Inc & Growth, HI, 2500/1000/50

AmCent Utilities, AA, 2500/1000/50

Dreyfus Aggressive Value, HI, 2500/750/100

Excelsior Value & Restruct, HI, 500/250/50

Marshall Equity Inc, AA, 1000/1000/50

Preferred Value, AA, 1000/250/50

Strong Value, 2500/250/50

TRP Equity-Income, AA, 2500/1000/50

Aquinas Equity Growth, HI, 500/500/50

Ariel Appreciation, HI, 1000/250/50

Chicago Trust Talon, AA, 2500/500/50

Fidelity OTC, AA, 2500/ 500/100

Invesco Dynamics, AA, 1000/250/50

Invesco Technology, 1000/250/50

Nicholas II, HI, 500/500/500

Oberweis Midcap, 1000/1000/100

Strong Growth, 1000/250/50

Strong Growth 20, 2500/250/50

TRP Capital Opport, AA, 2500/1000/50

TRP Mid-Cap Growth, HI, 2500/1000/50

TRP Sci & Tech, 2500/1000/50

USAA Growth, AA, 3000/250/100

Midcap Blend

Ariel Growth, HI, 1000/250/50

Artisan Midcap, 1000/1000/50

Excelsior Inc & Gr, AA, 500/250/50

Gabelli Asset, AA, 1000/1000/0

Green Century Equity, 2000/500/100

Mairs & Power Growth, AA, 2500/1000/100

Neu&Berman Soc Resp, AA, 1000/250/100

Nicholas, HI, 500/500/500

Strong Mid Cap, 2500/250/50

Strong Opportunity, AA, 1000/250/50

TRP New American Growth, AA, 2500/1000/50

Midcap Value

AmCent Equity Inc, AA, 2500/1000/50

AmCent Value, AA, 2500/1000/50

Ariel Appreciation, HI, 1000/250/50

Eclipse Growth & Inc, HI, 1000/1000/50

Heartland Large Cap, 1000/500/50

Heartland Mid Cap, 1000/500/50

IMS Capital Value, 5000/2000/100

Muhlenkamp, AA, 200/0/200

Neu&Berman Partners, AA, 1000/250/100

Safeco US Value, 1000/250/0

TRP Mid-Cap Value, 2500/1000/50

TRP Value, HI, 2500/1000/50

Small Growth

AmCent New Opportunities, 2500/1000/50

Columbia Small Cap, 2000/2000/50

Fasciano, AA, 1000/1000/0

Fremont U.S. Micro-Cap, AA, 2000/1000/50

Fremont U.S. Small Cap, 2000/1000/50

Marshall Small Cap, 1000/1000/50

Oberweis Micro-Cap, 1000/1000/100

TRP Diversif Sm Cap Growth, 2500/1000/50

Transam Premier Sm Cap, 1000/250/50

USAA Aggressive Growth, AA, 3000/250/100

Small Blend

Babson Enterprise II, AA, 1000/250/100

Crabbe Huson Small Cap, 2000/1000/100

Dreyfus Emerging Leaders, HI, 2500/750/100

FMI Focus, 1000/1000/50

Gabelli Westwood Small Cap, 1000/250/0

Neuberger & Berman Genesis, AA, 1000/250/100

Safeco Growth, HI, 1000/250/0

Safeco Small Co, 1000/250/0

TRP Small Cap Stock, AA, 2500/1000/50

Artisan Small Cap Value, 1000/1000/50

Dreyfus Small Cap Value, AA, 2500/750/100

Eclipse Equity, HI, 1000/1000/50

First Omaha Small Cap Value, 500/500/100

Gabelli Small Cap Growth, 1000/1000/0

Lindner/Ryback Small Cap, HI, 3000/250/50

Preferred Small Cap, 1000/250/50

Shadow Stock, 2500/250/100

Strong Small Cap Value, 2500/250/50

Westcore Small Cap Opp, AA, 1000/250/50

Domestic Hybrid Funds

Chicago Trust Balanced, HI, 2500/500/50

Columbia Balanced, AA, 1000/1000/50

Eclipse Balanced, AA, 1000/1000/50

First Omaha Balanced, 500/500/100

Founders Balanced, AA, 1000/500/50

Gabelli Westwood Balanced, AA, 1000/1000/0

Invesco Balanced, AA, 1000/250/50

Invesco Total Return, AA, 1000/250/50

Monetta Balanced, 250/250/25

Montag & Caldwell Balanced, HI, 2500/500/50

Nations Balanced, AA, 1000/500/100

Pax World, HI, 250/250/250

Preferred Asset Allocation, HI, 1000/250/50

Safeco Balanced, 1000/250/100

Scout Balanced, 1000/250/100

TRP Balanced, AA, 2500/1000/50

TRP Capital Apprec, AA, 2500/1000/50

TIAA-CREF Managed Alloc, 250/0/25

USAA Balanced, 3000/250/100

Diversified International and Global Funds

AmCent-20thC I Gr, HI, 2500/1000/50

Artisan I, 1000/1000/50

Columbia I, AA, 1000/1000/50

Founders I, 1000/500/50

Founders Passport, AA, 1000/500/50

Invesco European, HI, 1000/250/50

Neu&Berman I, AA, 1000/250/100

Safeco I, 1000/250/100

TIAA-CREF I, 250/0/25

TRP European, AA, 2500/1000/50

TRP Global, 2500/1000/50

TRP I Stock, AA, 2500/1000/50

TRP Spectrum I, 2500/1000/50

UMB Scout Worldwide, HI, 1000/250/100